Would Stimulus without Debt Work

may have wanted to replenish his declining checking or savings account, or buy a corporate bond, or a corporate stock, or pay taxes, or pay down debt, or buy goods or services, and he was willing to give up the bond to do it. The typical bond seller has much higher wealth and income than the typical tax-rebate recipient. It seems likely that money used to send tax rebates to households will increase aggregate demand for goods and services much more than if that same money were used to buy government bonds from bondholders willing to sell some bonds.

After full-employment output is achieved by the stimuluswithout-debt policy, confidence has returned to normal, and the tax rebates to households have been phased out, there will be more money in the economy than before due to the tax rebates. If the ruler thinks this extra money might cause too much spending and therefore inflation, the ruler can remove it from the economy by temporarily cutting government spending so it is less than tax revenue, or by temporarily raising tax revenue so it is greater than government spending. Either action results in more money coming into the government than the government spends. The government can remove this surplus money from the economy until money in the economy is back to normal. Then government spending can be set equal to tax revenue.

Whose Writing Guided the Benevolent Ruler?

When the benevolent ruler was asked whose writing was most influential, the ruler replied that the greatest influence came from two economists: John Maynard Keynes and Abba Lerner. The ruler said Keynes (1936) taught the crucial importance of aggregate demand for goods and services: if aggregate demand falls, it causes the economy to go into recession, so demand must be raised. Keynes warned that in a recession monetary

stimulus—lowering interest rates—would prove too weak to raise demand up to normal. He therefore recommended that the government increase its spending.

The ruler said that Lerner specifically recommended printing money to pay for fiscal stimulus (an increase in government transfers to households, an increase in government purchases of goods and services, and/or a decrease in taxes on households) to combat a recession. Lerner said that government should practice “functional finance,” not “sound finance,” and explained why in his “functional finance” chapter in each of his two books (Lerner 1944, 1951). The title of his 1944 book is The Economics of Control, and the title of his 1951 book is The Economics of Employment. The ruler also cited chapter 1 of his 1951 book, entitled “The Economic Steering Wheel,” as particularly clever and insightful. Lerner wrote that if the unemployment rate is above normal, the government should decrease taxes so households spend more, or increase its own spending and pay for the excess of spending over taxes by printing money instead of borrowing. But won’t printing money be inflationary? Lerner said it would indeed be inflationary if it were done when there is already full employment. Why? Because with full employment each firm can attract employed workers away from other firms only by raising wages, which increases costs and compels firms to raise prices. But if it were done when unemployment is high, firms would be able to attract unemployed workers without raising wages, so there would be no cost increases, and no need for firms to raise prices.

Lessons for Combating Recession with Actual Institutions

It should be possible to implement stimulus without debt under our actual institutions because the benevolent ruler was able to

do it. Congress and the president should control government spending, taxes, and fiscal stimulus, with the Treasury as their administrative agent. The Federal Reserve should control the printing of money and its injection into or withdrawal from the economy. With this institutional separation of powers, how would stimulus without debt be implemented in a recession?

The Federal Reserve would decide whether to give a transfer (not loan) to the Treasury to be used for fiscal stimulus, and if so, how much. The Fed would make its decision by estimating the depth of the recession and the magnitude of the fiscal stimulus needed to combat it. If all transactions were conducted using Federal Reserve notes (not by writing checks or crediting bank accounts), the Fed would print new Federal Reserve notes in the amount it wanted to transfer to the Treasury. In practice, the Fed would either write a check to the Treasury or credit the Treasury’s checking account at the Fed, and print the amount of new Fed notes needed to meet requests for Fed notes from banks and the public. The Fed would continue to use its standard instruments of monetary policy such as sales or purchases of government bonds in the open market, and decide how to adjust these sales and purchases in light of the Fed’s transfer to the Treasury for fiscal stimulus.

Congress and the president would decide how much fiscal stimulus to enact in light of the magnitude of the transfer the Fed was willing to give to the Treasury for fiscal stimulus. They could enact a larger fiscal stimulus than the Fed’s transfer to the Treasury, but the Treasury would have to borrow the difference. If they enacted a smaller fiscal stimulus than the Fed’s transfer to the Treasury for fiscal stimulus, some of the Fed’s transfer would go unused and be returned to the Fed. Congress and the president would decide the composition as well as the size of the fiscal stimulus. As I will explain shortly, I recommend that a large portion of the fiscal stimulus be tax rebates to households.

Conclusion

The most important point is this: fiscal stimulus does not require an increase in government debt. To get high unemployment down to normal, the government should implement fiscal stimulus: increase its spending (mainly tax rebates to households, but also some purchases of goods and services and other expenditures) and/or cut taxes. When the government does this, it doesn’t need to borrow. It can get the money it needs from its printing press. As long as it does this only when unemployment is high, it will not be inflationary. Thus, when unemployment is high, fiscal stimulus can be implemented without debt and without causing inflation.

Chapter 3

What Is Stimulus without Debt?

“Stimulus without debt” is a policy that would increase aggregate demand for goods and services in a recession without increasing government debt. Stimulus without debt consists of a transfer (not loan) from the central bank to the nation’s treasury so that the treasury does not have to borrow to finance fiscal stimulus enacted by the legislature. In most of this book I illustrate stimulus without debt with reference to the United States, but stimulus without debt can be implemented in other countries and in the eurozone.

The Strategy behind Stimulus without Debt

Most recessions, including the US Great Recession of 2008, involve a fall in demand for goods and services. When the US housing bubble burst in 2007, followed by the plunge in the stock market and the failure of firms like Lehman Brothers in 2008, consumer wealth and confidence fell sharply. Anxious consumers cut back their spending, so consumer demand for goods and

services fell. Producers of consumer goods and services had no choice but to cut back production and lay off workers. Business firms reacted to this fall in consumer demand by cutting their demand for investment goods—why expand plant and equipment to produce more when consumers won’t buy more? In response to the fall in consumption and investment demand, firms cut back production and employment. To combat a severe recession involving a sharp fall in aggregate demand for goods and services, fiscal stimulus (an increase in government transfers to households, an increase in government purchases or goods and services, and/or a decrease in taxes on households) must be enacted to increase aggregate demand for goods and services because monetary stimulus—lowering interest rates—alone is too weak to combat a severe recession (Seidman 2001, 2003, 2011, 2012a, 2012b).

Under stimulus without debt, Congress would enact a fiscal stimulus package that consists mainly of cash transfers (tax rebates) to households but also other temporary expenditures and temporary tax cuts; the fiscal stimulus would raise aggregate demand. The Federal Reserve would use new money to give a large transfer (not loan) to the Treasury equal to the fiscal stimulus package so that the Treasury would not have to borrow to pay for the package. Hence, there would be no increase in government debt (Seidman 2013). The Fed’s transfer to the Treasury injects an amount of money into the economy that is equal to the Fed’s transfer. By contrast, fiscal stimulus alone would require the Treasury to borrow an amount equal to the fiscal stimulus by selling new government bonds, thereby significantly increasing government debt.

Stimulus without debt differs crucially from a standard fiscalmonetary stimulus. Under a standard fiscal-monetary stimulus, the Treasury borrows to pay for the fiscal stimulus by selling new government bonds to the public, and the Federal Reserve

enters the “open market” and buys an equal amount of government bonds from the public. Government debt increases by the amount of the fiscal stimulus, and the Fed increases its holding of Treasury bonds by the same amount. A crucial point is that the Fed’s action does not prevent the increase in Treasury debt outstanding: official Treasury debt increases by an amount equal to the fiscal stimulus. Money injected into the economy is the same under stimulus without debt and standard fiscal-monetary stimulus, but government debt is greater under standard fiscalmonetary stimulus.

Official government debt includes all Treasury bonds outstanding whether held by the public or by the Fed. But should it include Treasury bonds held by the Fed? My answer is yes. It is true that the Fed returns to the Treasury most of the interest it receives from the Treasury. But at any moment, the Fed can decide to sell Treasury bonds to the public, and the public will expect principal and interest to be paid on schedule. Thus, the Treasury must be ready to pay principal and interest on schedule on all Treasury bonds outstanding, including bonds held by the Fed. Congress, the Treasury, and the citizenry are therefore correct to focus on the official government debt figure that includes bonds held by the Fed; and they would be correct to oppose excluding bonds held by the Fed from official government debt. Thus, the difference between stimulus without debt and standard fiscalmonetary stimulus is genuine both in theory and in practice.

Government paper money held by the public is not government debt. Government paper money was government debt a century ago when the government promised gold to any holder of government paper money who requested it. But when the government removed its promise to provide gold or anything else to the holders of government paper moneypaper money ceased to be government debt because the government owes nothing to holders of its paper money. By contrast, government

bonds are government debt because the government promises to pay government paper money—principal plus interest—on schedule to all holders of government bonds; the government owes government paper money to holders of government bonds. Fiscal stimulus without debt, therefore, means fiscal stimulus without an increase in government bonds.

I have two important reasons for proposing fiscal stimulus without debt instead of the standard fiscal stimulus with debt. The first reason is political and the second reason is economic. My political reason comes from facing the fact that many policymakers, financial investors, citizens, and economists believe that large government debt will generate negative economic consequences and risks in the future, so they oppose enactment of a large fiscal stimulus in a severe recession if it causes a large increase in government debt. Without the stimulus-withoutdebt plan proposed in this book, a fiscal stimulus large enough to combat a severe recession would cause a large increase in government debt—and it is therefore unlikely to be enacted by Congress. By contrast, with the stimulus plan proposed here, even a large fiscal stimulus would cause no increase in government debt. The stimulus-without-debt plan would therefore remove one key obstacle to obtaining the support of policymakers and the general public for a large fiscal stimulus in a severe recession.

My economic reason is that large government debt—that is, government debt that is a large percentage of GDP—may generate negative economic consequences and risks in the future. Although large government debt may not lead to this negative scenario, it is a risk that is worth avoiding: (1) If interest rates rise in the future, large debt will result in large interest payments; (2) large interest payments will force Congress to raise taxes or cut spending or borrow more; (3) more government borrowing and still larger government debt may at some point make financial investors anxious and cause them to sell corporate stocks,

resulting in a fall in the stock market; (4) a fall in the stock market would reduce wealth and confidence and cause consumers and businesses to cut spending, precipitating a recession; (5) the fall in the stock market and the recession would generate still more anxiety among financial investors and managers, generating a financial crisis, worsening the recession. Thus, the public and Congress are right to be concerned about the possible negative economic consequences of letting government debt become a large percentage of GDP.

The phrase “stimulus without debt” also means “without private debt.” Standard monetary stimulus reduces interest rates in order to induce households and/or businesses to borrow more in order to spend more on goods and services, so standard monetary stimulus works by inducing households and firms to incur more private debt in order to spend more on goods and services. By contrast, fiscal stimulus in the form of tax rebates (cash transfers) to households enables recipients to spend more without increasing their debt; empirical studies that I will review later show that households spend a significant portion of their tax rebate and use the remaining portion to pay down debt and save.

Under the stimulus-without-debt policy, the Federal Reserve would transfer (not lend) X dollars to the Treasury. In turn, the Treasury, after authorization by Congress, would mail out a large portion of the X dollars as “tax rebate” checks (cash transfers) to households (a small portion of the X dollars would be spent on other kinds of fiscal stimulus such as temporary government purchases of goods and services or temporary tax cuts). Thus, the Treasury would not have to borrow to finance X dollars of fiscal stimulus because of the Fed’s transfer (not loan) of X dollars to the Treasury. Moreover, households would spend some or most of their tax rebate without doing any borrowing. Thus, this policy would increase aggregate demand for goods and services without increasing government debt or private debt.

The stimulus-without-debt plan is designed to maintain a separation of powers and checks and balances: both Congress and the Federal Reserve play crucial independent roles. Congress sets the size and composition of the fiscal stimulus package. The Federal Reserve decides the size of the transfer (not loan) it will make to the Treasury; the Fed therefore sets the amount of fiscal stimulus that can be implemented without increasing government debt, but Congress is free to enact a fiscal stimulus that is larger or smaller than the Fed’s transfer to the Treasury.

The plan for stimulus without debt in a recession has five elements:

1. If the Federal Reserve judges that the GDP of the economy is significantly below the Fed’s estimate of potential GDP, the Fed would decide whether to give a transfer (not a loan) to the Treasury, and if so, how much, on the condition that it be used only for fiscal stimulus. Authority for the Fed to make this transfer might require an amendment to the Federal Reserve Act. The Fed could implement its transfer by writing a check to the Treasury or crediting the

Treasury’s checking account at the Fed. 2. Congress would decide whether to enact fiscal stimulus, and if so, how much; its main component would be tax rebates to households, though other components should also be included in the fiscal stimulus package. The Treasury would mail tax rebate checks to households in amounts specified by Congress. 3. If the amount Congress enacts for fiscal stimulus is no greater than the Fed’s transfer, then the Treasury would not have to borrow to finance the fiscal stimulus; if the fiscal stimulus is greater than the Fed’s transfer, the

Treasury would have to borrow the difference.

4. The Fed would decide how much to adjust its bond purchases or sales to try to keep employment high and inflation low.

It is very likely that the Fed, having injected money into the economy through its transfer to the Treasury, would decide either to inject less money into the economy through bond purchases or to withdraw money from the economy through bond sales. 5. The Fed would order (from the Treasury’s Bureau of

Engraving and Printing) an amount of new Federal Reserve notes equal to its transfer to the Treasury, and would store these notes in the Fed’s vault; this Fed vault cash would be an asset on the Fed’s balance sheet, and as a consequence of this new vault cash the Fed’s transfer to the Treasury would not reduce the Fed’s capital (net worth) on its balance sheet.

Would Stimulus without Debt Be Temporary or Permanent?

In response to a recession caused by a shock like a plunge in housing prices or stock prices, stimulus without debt would be a temporary policy. As the economy recovers toward full employment and consumer and business confidence returns, stimulus without debt would be gradually phased out: Congress would slow the growth of government spending and/or raise taxes, thereby reducing fiscal stimulus; and the Fed would reduce the growth of money in the economy, thereby reducing monetary stimulus; the Fed would do this by buying a smaller amount of bonds from the public than it otherwise would have bought.

When the economy plunges into recession, surveys confirm the obvious: consumer and business confidence and expectations for the economy fall sharply. The fiscal stimulus in stimulus

without debt, primarily tax rebates to households, would initially be set large enough so that, even with low consumer and business confidence and expectations, spending on goods and services would increase enough to launch a strong recovery. As a solid recovery takes hold, surveys again confirm the obvious: consumer and business confidence and expectations start rising. This rise in confidence and expectations raises demand for goods and services. As confidence and expectations return to normal, stimulus can be gradually phased out.

Some macroeconomists have ignored the role of confidence and expectations in determining demand for goods and services, and the role of the state of the economy in determining confidence and expectations. But many economists and laymen rightly regard the connection, confirmed by surveys and anecdotes, as obvious. As the economy moves from recession to a strong recovery generated by stimulus, confidence and expectations will rise in step with the economy, thereby enabling the gradual phasing out of the stimulus.

There is one caveat. Suppose the economy hasn’t plunged into recession due to a shock like a plunge in housing prices or stock prices, but has instead experienced a gradual decline in demand relative to potential output—a “demand-induced secular stagnation.” If demand-induced secular stagnation is really a problem, could stimulus without debt treat it? Should it? With secular stagnation, would the treatment have to be permanent rather than temporary? I will discuss this at the end of this book.

Tax Rebates to Households

The purpose of having the US Treasury mail a tax rebate check (a rebate of a portion of the income, payroll, and sales taxes paid by the household in the previous year) to every household

in a recession is to increase consumption spending and thereby stimulate production of goods and services. Strong evidence for a significant impact of tax rebates on consumption spending will be presented in depth in the next chapter. A tax rebate to households is one type of fiscal stimulus (tax cuts and/or government spending).

A tax rebate is a giving back to each taxpayer a portion of the taxes (income, payroll, and sales) that the taxpayer paid in the previous year. Congress does this in a recession to help citizens cope with the recession and to boost their spending on goods and services, which will stimulate production and employment.

Why focus on tax rebates to households rather than other kinds of fiscal stimulus? There are at least eight reasons. First, and most important, as I will document in chapter 4, tax rebates work: a significant portion of tax rebates are spent within half a year of being received. This should not be surprising. Both surveys of recipients and econometric analysis of spending data following the payment of tax rebates indicate that households spend a significant portion of it: one-third within three months and two-thirds within six months. Note: any recession almost always involves a fall in consumption below its trend growth path.

Second, tax rebates clearly increase household spending on all goods and services rather just a subset of goods and services, so all businesses would recognize that rebates boost customer demand for their goods or services. Third, with tax rebates, there would be no “shovel-ready” problem that may occur with infrastructure projects; there is no limit to how much households can spend promptly on goods and services. Fourth, with tax rebates there would be no temporary or permanent increase in the size of government: rebates simply give spending power to millions of individual consumers, whose spending stimulates the private sector. Fifth, tax rebates to combat a recession are clearly temporary and require a new vote by Congress to be continued. Sixth, every

household would receive a rebate check in the mail from the US Treasury, so every voter would actually see a concrete personal benefit from this kind of fiscal stimulus. Seventh, the inclusion of every household would cause most voters to regard tax rebates as a fair way to implement fiscal stimulus. Eighth, rebates have been enacted with bipartisan support three times—1975, 2001, and 2008. Thus, a tax rebate has many important advantages as an instrument for fiscal stimulus in a recession.

There is a good reason why tax rebates were able to pass with bipartisan support three times. Conservatives and liberals, Republicans and Democrats, have differing long-term agendas for government spending and taxation. For example, conservatives generally want permanent tax cuts, while liberals want permanent increases in social insurance and education programs. Neither side wants an antirecession stimulus that would advance the agenda of the other side if it became permanent. Tax rebates are obviously and inherently temporary. They do not favor the long-term agenda of either side. This is undoubtedly one reason that tax rebates were enacted three times with bipartisan support, whereas most other proposals, such as permanent tax cuts, or permanent increases in social insurance or education programs, have generated partisan opposition. The tax rebate does not favor one side’s long-term agenda over the other. It is neutral toward long-term agendas. The details of the design of a tax rebate in recession will be discussed in the last section of chapter 4.

A Transfer from the Fed to the Treasury in a Recession

The purpose of the Fed’s transfer to the Treasury in a recession is to enable the Treasury to pay tax rebates to households and undertake other fiscal stimulus without borrowing. The Fed’s

transfer to the Treasury is not a loan; the Fed would not receive Treasury bonds in return for its funds. If the Federal Open Market Committee (FOMC) judges that the total amount of tax rebates chosen by Congress is appropriate to the severity of the recession, the FOMC would decide to make its transfer roughly equal to the total amount of the tax rebates so that the rebates don’t increase the debt of the federal government.

Later in this chapter, I will explain why the Fed should have transferred $450 billion to the Treasury every six months from June 2008 through December 2010, six transfers summing to $2,700 billion, and Congress should have authorized $450 billion of fiscal stimulus every six months from June 2008 through December 2010, so each year there would have been $900 billion of fiscal stimulus—6% of GDP ($15,000 billion). Most of the fiscal stimulus should have been tax rebates to households. The fiscal stimulus would not have required any new borrowing by the Treasury—it would not have required any sale of new Treasury bonds. Thanks to the Fed’s transfer to the Treasury, the fiscal stimulus would not have increased federal debt.

What the Federal Reserve Would Do under Stimulus without Debt

It is important to distinguish between two roles for the Federal Reserve when the economy suffers a plunge in aggregate demand resulting in a severe recession: (1) acting aggressively as a lender of last resort to perform financial rescues and unfreeze credit markets; (2) cutting interest rates to try to induce households and firms to maintain borrowing and spending. The Fed should do both aggressively. The first role can succeed; the second role can help, but cutting interest rates is not nearly powerful enough to overcome a severe recession.

The recession began in late 2007 in response to the plunge in housing prices but proceeded moderately through the first half of 2008 with below-normal growth in aggregate demand. In September 2008, however, in part due to the failure of Lehman Brothers, a financial crisis was triggered as fear swept over managers of financial institutions and investors that they might follow Lehman Brothers to a similar fate. Institutions and investors sought liquidity and sharply cut their lending.

In a financial crisis, the Federal Reserve has a vital role to play as a lender of last resort, providing emergency loans to financial institutions and other firms in order to prevent the freezing up of credit markets and to keep funds flowing to business firms so that production can continue. The Fed and the Treasury aggressively engaged in financial rescues in the fall of 2008 and the winter of 2009. In my judgment, these actions were essential to preventing a full-scale great depression. The Fed must also make sure that interest rates are cut sharply to zero in order to give households and firms as much inducement as possible to keep borrowing and spending. The Fed also performed this task well in 2008.

But a key question then becomes whether the Fed’s sharp cut in interest rates is enough to stimulate a sufficiently large increase in aggregate demand for goods and services in a severe recession. When the Federal Reserve wants to stimulate demand for goods and services, its standard method is to lower interest rates in the hope that consumers and businesses will respond by borrowing more in order to spend more on goods and services. The Fed buys US Treasury bonds from financial firms and other institutions. When the Fed writes checks to buy the bonds, it is injecting money into the economy. When the sellers of these bonds receive checks from the Fed, they deposit the checks in their banks. The banks try to induce households and firms to borrow by cutting interest rates. But in a severe recession, it is

doubtful that cutting interest rates can induce enough borrowing and spending to fully reverse a deep plunge in aggregate demand because in a deep recession people and businesses are pessimistic and reluctant to take on more debt.

Under the stimulus-without-debt policy, the Fed injects money into the economy a new way. When the Fed transfers X dollars to the Treasury, it injects X dollars of high-powered money into the economy because the Treasury, after authorization by Congress, mails out most of the transferred X dollars as tax rebates to households and spends the rest. The Fed would decide how much to adjust its bond purchases or sales to try to keep employment high and inflation low; it is likely that the Fed, having injected money into the economy through its transfer to the Treasury, would inject less money into the economy through bond purchases or would withdraw money from the economy through bond sales.

Under the stimulus-without-debt policy, the Fed would order X dollars of new Federal Reserve notes and store these notes in its vault. This vault cash would be an asset on the Fed’s balance sheet. As a consequence of this action, the stimulus without debt would have no effect on the Fed’s net worth (capital) on its balance sheet.

Money for Tax Rebates versus Money to Buy Government Bonds

Now let me compare money for tax rebates versus money to buy government bonds. Under stimulus without debt, the Fed creates money and uses it to make a large transfer to the Treasury, which, at Congress’s request, uses the money to pay tax rebates to households. By contrast, under standard monetary stimulus, the Fed creates money and uses it to buy government bonds “in

the open market” from members of the public who want to sell government bonds that they previously bought. Which of these two uses of new money created by the Fed is likely to cause a larger increase in aggregate demand for goods and services?

A person who receives a tax rebate realizes she can spend more, save more, and pay down more debt. The rebate increases her wealth, enabling her to do all three. But when someone sells a government bond, the seller realizes her wealth is the same because the cash replaces her bond. The seller may have sold the bond to replenish her declining checking or savings account, or buy a corporate bond, or a corporate stock, or pay taxes, or pay down debt, or buy goods or services, and was willing to give up the bond to do it. The typical bond seller has much higher wealth and income than the typical rebate recipient. It seems likely that money used for tax rebates will increase aggregate demand for goods and services more than if that same money were used to buy government bonds. Thus, to increase aggregate demand, paying rebates is likely to be a more efficient use of money by the government than buying bonds.

Debt Worry Prevents Sufficient Stimulus in a Big Recession

Influential economists have warned against enacting a very large fiscal stimulus to combat a severe recession because they worry about the rise in government debt that it will generate (Seidman 2011, 2012a, 2012b, 2013). I believe some economists have exaggerated the risks of the resulting rise in government debt. But I will now cite a few economists to show that a very large fiscal stimulus in a severe recession will be opposed by influential economists as long as it generates a very large increase in debt.

Olivier Blanchard, for many years a professor of economics at MIT and then chief economist of the International Monetary Fund during part of the Great Recession, supported some fiscal stimulus during the Great Recession but opposed a fiscal stimulus that would have been large enough to overcome that recession. He explained why in a section of his intermediate macroeconomics textbook entitled “High Debt, Default Risk, and Vicious Cycles” (2017). If financial investors start worrying about whether the government can fully pay principal plus interest on schedule for all its bonds held by the public (domestic and foreign), they will refuse to buy new government bonds unless the bonds offer high interest rates to compensate for default risk; but these high interest rates on government bonds will make it even harder for the government to fully pay principal plus interest on schedule. To avoid this scenario, Blanchard argues that each government must limit its fiscal stimulus in a recession so that its debt doesn’t get high enough to worry financial investors.

Carmen Reinhart and Kenneth Rogoff, the authors of This Time Is Different: Eight Centuries of Financial Folly (2009), presented a paper (2010) at the American Economic Association’s annual conference in which they asserted that their empirical study of data from many countries over the past two centuries found that government debt greater than 90% of GDP on average reduces a country’s annual economic growth rate by one percentage point—for example, from 3% to 2%—in this example, a 33% reduction in the growth rate. Their paper received a lot of attention and publicity. They said the sharp rise in government debt as a percentage of GDP during the Great Recession was worrisome because it might slow future economic growth. They implied that fiscal stimulus to combat a recession should therefore be limited. They said that when government debt as a percentage of GDP

rises to a high level, it is likely that financial markets will at some point generate a sharp jump in market interest rates, resulting in slower economic growth.

The Reinhart-Rogoff assertion that debt over 90% of GDP it likely to result in slower economic growth has been persuasively challenged by Herndon, Ash, and Pollin (2014) and others. But the Reinhart and Rogoff paper, especially their 90% threshold, has received much more publicity and attention than the replies of critics; I suspect their claim of a 90% threshold has persuaded some economists and policymakers to oppose fiscal stimulus in a recession.

My 2013 Article Entitled “Stimulus without Debt”

In 2013 I proposed and explained “stimulus without debt” in an article with that title in the economic policy journal Challenge (Seidman 2013). My article began by noting that a grim lesson from the Great Recession is that widespread worry about government debt generates strong political resistance to enacting a fiscal stimulus large enough to overcome a severe recession. But fortunately there is a way to implement fiscal stimulus in a recession without increasing government debt. I stated that the purpose of my article was to explain and defend a “stimulus without debt” plan under which fiscal stimulus enacted by Congress would be accompanied by a transfer from the Federal Reserve to the US Treasury of the same magnitude so that the Treasury would not have to borrow to finance the fiscal stimulus.

I then contrasted stimulus without debt with standard fiscalmonetary stimulus. Under standard stimulus, Congress cuts taxes or raises government spending (transfers or purchases) in order to raise aggregate demand for goods and services, and

the Treasury borrows an amount equal to the fiscal stimulus by selling US Treasury bonds to the public, thereby increasing government (Treasury) debt held by the public. The Fed then buys an equal amount of Treasury bonds from the public in the open market so that the Fed, not the public, ends up holding the increase in Treasury debt. A crucial point is that the Fed’s action does not reverse the increase in Treasury debt: official Treasury debt increases by an amount equal to the fiscal stimulus, whether or not the Fed buys Treasury bonds from the public. Standard stimulus involves monetizing the debt; it does not prevent debt from being issued by the Treasury

I set out the two key components of stimulus without debt. The first component of the stimulus-without-debt plan is fiscal stimulus (an increase in government spending and/or tax cut) enacted by Congress. My recommendation for fiscal stimulus is a tax rebate for households supplemented by other kinds of fiscal stimulus. A tax rebate was implemented during the US recessions in 1975, 2001, and 2008. The second component of the stimuluswithout-debt plan is a transfer from the Federal Reserve to the Treasury. In a severe recession the Federal Open Market Committee would give a transfer to the Treasury in an amount decided by the FOMC that, in its judgment, would promote the Federal Reserve’s dual legislative mandate—enacted years ago by Congress—of promoting both high employment and low inflation. It must be emphasized that the Federal Reserve would not be buying bonds from the Treasury; the Treasury would not be incurring a debt—it would be receiving a transfer.

I emphasized that a crucial feature of the stimulus-withoutdebt plan is that it preserves the separation of powers and checks and balances in the implementation of fiscal and monetary policy. The first component—fiscal stimulus—is under the control of Congress (and the president, whose signature is required unless Congress can obtain a two-thirds majority to

override the president’s veto) but not the Federal Reserve. The second component—the transfer from the Federal Reserve to the Treasury—is under the control of the Federal Reserve but not Congress.

Stimulus without Debt versus Alternative Stimulus Plans

I will now contrast stimulus without debt with the following alternatives: (1) helicopter money; (2) monetizing the debt; (3) quantitative easing by the Federal Reserve; (4) transfers from the Federal Reserve to households; (5) money creation by the Treasury as authorized by Congress; (6) not counting bonds held by the Federal Reserve as official government debt; (7) having the Fed burn or shred Treasury bonds equal to the fiscal stimulus. Each alternative will be considered in turn.

Helicopter Money

Stimulus without debt is similar to “helicopter money” in certain ways but very different in others. The concept of helicopter money comes from a parable written by Milton Friedman in 1969 in which money is dropped on the population by a helicopter. Stimulus without debt is a policy in which the Federal Reserve gives a transfer to the Treasury, and the Treasury, after authorization by Congress, gives transfers (“tax rebates”) to the population. Hence, the similarity is that under both the parable and the policy, new money is given (not loaned) to the population.

In contrast to helicopter money, stimulus without debt specifies how to achieve a separation of powers by assigning particular roles to particular institutions in its practical implementation. In Friedman’s parable, the money in the economy

increases by the amount dropped from the helicopter. By contrast, under stimulus without debt, when the Fed injects money into the economy by giving a transfer to the Treasury, the Fed is likely to decide to inject less money buying Treasury bonds, so the increase in money in the economy is likely to be much less than the Fed’s transfer to the Treasury.

Finally, and most crucially, in Friedman’s parable the helicopter drops money on an economy that is at full employment, whereas the stimulus-without-debt policy should only to be used when the actual output of the economy is well below potential output. With the economy at full employment, giving money to the population would lead to spending that raises prices, not output. Friedman ignored what would happen if the economy were in recession. In that important case, giving money to the population would lead to spending that raises output, not prices. In chapter 11 I look at recent writing by other economists on helicopter money.

Monetizing the Debt

The stimulus-without-debt plan proposed in this book does not involve “monetizing the debt” because it creates no debt to monetize: the Treasury sells no bonds, and no additional Treasury bonds are held by either the public or the Federal Reserve; the official federal debt stays constant. By contrast, standard fiscalmonetary stimulus involves “monetizing the debt”: the Treasury sells bonds to the public, the Fed buys Treasury bonds from the public, and official Treasury debt increases.

Quantitative Easing by the Federal Reserve

Under quantitative easing by the Fed, the Fed buys bonds in the open market and pays bond sellers with checks that the sellers

deposit in their banks, thereby increasing bank reserves, which is expected to lead to a reduction in the interest rates that banks offer borrowers, thereby raising borrowing and spending by households and business firms, resulting in more production and employment. To work, quantitative easing must therefore induce households and businesses to incur more debt.

But in a severe recession households and business firms are usually reluctant to run up more debt. A huge run-up of the ratio of household debt to household income was one cause of the Great Recession of 2008 and the Great Depression of 1929 (Mian and Sufi 2014). Just prior to each collapse, heavily indebted households became unwilling to borrow more in order to continue their spending, and spending collapsed. Standard monetary stimulus—lowering interest rates—was unable to stimulate a significant increase in consumer spending because deeply indebted households were trying to pay down some of the debt they incurred during the run-up.

Under stimulus without debt the Treasury mails tax rebate checks to households in order to raise households’ ability to spend more without incurring more household debt. With tax rebates, households use some of their rebate to pay down debt, some for saving, and some to increase their spending.

Transfers from the Federal Reserve to Households

Under Federal Reserve transfers to households, in a recession the Fed would give each household a transfer—for example, $2,000 per adult plus $1,000 per child. To implement this transfer, the Fed would have to obtain the addresses of millions of households—presumably from the Internal Revenue Service—or request that the IRS do the mailing for the Fed; the IRS would need the approval of Congress either to provide the Fed with taxpayers’ mailing addresses, or to do the mailing on

behalf of the Fed. Under this plan the Fed, not Congress, would specify the dollar amount that would be sent to each household. Many citizens, as well as members of Congress, might question the appropriateness of the central bank, rather than Congress, deciding the specific amounts to go to each household.

By contrast, the stimulus-without-debt plan preserves a separation of powers in which Congress retains control over the amount sent to each household and the Federal Reserve’s decision is limited to the total amount of the transfer it gives to the Treasury. When Congress enacted tax rebates for households in 1975, 2001, and 2008, no one questioned the appropriateness of Congress deciding the specific amounts that would go to each household. By contrast, many might question the appropriateness of the Federal Reserve deciding the specific amounts.

Moreover, as I will argue in chapter 5, there are good arguments for Congress to include several other kinds of fiscal stimulus in its fiscal stimulus package: specifically, temporary grants (transfers) from the federal government to state governments, temporary tax incentives for business investment, and federal spending or grants to states for infrastructure maintenance projects. Most citizens would agree that Congress, not the Federal Reserve, should decide whether to include these kinds of fiscal stimulus.

Money Creation by the Treasury as Authorized by Congress

If there were no independent central bank, and instead Congress directly controlled not only government spending and taxes but also money creation, then in a recession Congress could set taxes below government spending and authorize the Treasury to create money, rather than sell bonds, to cover the difference. Under this plan, Congress would enact tax rebates for households—for example, $450 billion—and then authorize the Treasury to create

$450 billion of new money to pay for the rebates. Money creation by the Treasury would eliminate the need for the Treasury to borrow $450 billion by selling bonds, so there would be no increase in government debt. Nor would there be any participation by the Federal Reserve under this plan. Congress would enact the fiscal stimulus and then authorize the Treasury to create the money to pay for it rather than borrow.

But if Congress authorizes money creation by the Treasury, then there would be a breakdown of the current separation of powers and checks and balances. Congress would directly control money creation as well as spending and taxation. This would enable Congress to set government spending well above taxes in a normal economy when no stimulus is warranted, and create money to cover the difference, thereby unilaterally injecting a combined fiscal-monetary stimulus that overheats the economy and generates inflation. By contrast, under the stimulus-withoutdebt plan, Congress, not the Federal Reserve, would authorize the tax rebates to households, and the Federal Reserve, not Congress, would decide the specific amount of money to transfer to the Treasury.

Not Counting Treasury Bonds Held by the Fed as Government Debt

Under this plan, the US Treasury and the Congressional Budget Office (CBO) would be instructed by Congress to exclude Treasury bonds held by the Federal Reserve from the calculation of official US government debt. I once argued (Seidman 2001, 2003) that Treasury bonds held by the Fed should not be officially counted as government debt because the Fed is a special lenient creditor. In contrast to other holders of Treasury bonds, the Fed returns most of the interest earned on its Treasury bonds to the Treasury.

But I now realize that not counting Treasury bonds held by the Fed has a fatal flaw. The Fed may at any time sell these Treasury bonds to the domestic or foreign public, which will, in contrast to the Fed, expect and demand full interest and principal payments from the Treasury on schedule. Thus, the Treasury must be ready to pay the principal and interest for these bonds on schedule in case they are sold by the Fed to the public. Hence, not counting Treasury bonds as part of government debt just because they are currently held by the Fed would understate how much the Treasury might be obligated to pay in the future. Thus, policymakers, members of Congress, financial investors, and the public would be fully justified in insisting that Treasury bonds held by the Fed should continue to be counted as part of official government debt.

Having the Fed Burn or Shred Treasury Bonds

Under the “bond-burning” plan, the Treasury would finance the fiscal stimulus by selling new Treasury bonds to the public, the Fed would buy an equal amount of Treasury bonds from the public, and then the Fed would burn these bonds. I concede that the bond-burning plan should, in theory, have the same effect as stimulus without debt because both plans have the same fiscal stimulus, the same amount of money injected into the economy, the same constancy of government debt, and the same effect on the Fed’s balance sheet. The bond-burning plan can be made less incendiary by having the Fed “shred” rather than burn the bonds. The Treasury may prefer that the Fed give the bonds, without compensation, to the Treasury so that the Treasury can shred them and therefore be absolutely certain that they have been shredded.

So are there any reasons for preferring stimulus without debt to the bond-shredding plan? I think there are three. First, if the

bonds are going to be created only to be burned or shredded, why create them in the first place? My transfer from the Fed to the Treasury saves two steps: bond creation by the Treasury and bond shredding by the Fed or Treasury.

Second, I think stimulus without debt makes it much clearer to the public and Congress that there is no increase in government debt because the Treasury does not create or sell any new bonds—it does not borrow—to finance the fiscal stimulus. By contrast, under the bond-shredding plan, the Treasury creates and sells new bonds—it borrows—so the Treasury’s action in itself increases government debt. It is true that the shredding of bonds by the Fed or Treasury can keep government debt constant despite the Treasury’s creating and selling new bonds. But why make the public and Congress worry about whether the Treasury’s new borrowing and bond sales will be fully offset by later bond shredding?

Third, I suspect that a proposal for bond burning or shredding by the Fed or Treasury would be received more negatively by the public than stimulus without debt. Bond burning or shredding may seem like a trick that lets Congress off the hook for its borrowing; burning or shredding may seem immoral or bizarre. In contrast to burning or shredding bonds, the Fed writes checks every day in order to buy Treasury bonds in the open market or make loans to banks. Stimulus without debt simply proposes that the Fed write several checks to the Treasury (for transfers, not loans) so that Congress can combat a recession without requiring the Treasury to borrow.

Worry about Inflation

Would the stimulus-without-debt plan raise inflation? Under the plan, the magnitude of the stimulus would be set with the aim of

raising aggregate demand for goods and services just enough to achieve full employment. As long as demand for goods and services is not raised significantly above this level for a significant period of time, there would be little or no inflation. As consumer and business confidence rises in response to the economic recovery generated by stimulus without debt, the stimulus would be gradually phased out to avoid an excessive rise in the demand for goods and services once the economy has reached full employment. Chapter 6 explains in greater depth why stimulus without debt would not be inflationary.

Worry about the Fed’s Balance Sheet

How would the stimulus-without-debt plan affect the Fed’s balance sheet? If the Fed buys a Treasury bond in the open market, it obtains an asset, but if the Fed gives the Treasury a transfer, it obtains no asset. On the Fed’s balance sheet, the Fed’s “capital” (“net worth”), defined as assets minus liabilities, would therefore be lower if the Fed gave the Treasury a transfer instead of buying Treasury bonds. So at first glance, it might seem that stimulus without debt would cause the Fed to have a balancesheet problem.

But the Fed can avoid this balance-sheet problem. Under the stimulus-without-debt policy, just before the Fed makes its transfer to the Treasury, the Fed would order the printing of an amount of new Federal Reserve notes equal to its transfer to the Treasury and the Fed would then store these notes in the Fed’s vault. Cash in the Fed’s vault is a Fed asset on its balance sheet, so the Fed’s total assets would increase by an amount equal to the Fed’s transfer to the Treasury—the same increase in total assets that would have occurred if the Fed had instead spent the same amount of money buying Treasury bonds. With this

storing of new Federal Reserve notes in the Fed’s vault, stimulus without debt would not alter the Fed’s capital (net worth), just as the Fed’s purchase of Treasury bonds does not alter the Fed’s capital. Chapter 7 explains further why stimulus without debt would not weaken the Fed’s balance sheet.

Worry about Fed Independence

Worry: “Under the stimulus-without-debt plan, Congress will set the magnitude of its fiscal stimulus, and will then pressure the Federal Reserve to provide a transfer to the Treasury equal to the amount of the fiscal stimulus. Therefore, under this plan the Fed will sacrifice its independence. It will be compelled to provide the money Congress wants.”

But under the stimulus-without-debt plan, the Fed provides a transfer to the Treasury only if the Fed judges that this transfer would advance the Fed’s mandate, prescribed by Congress many years ago, of promoting high employment and low inflation. Under the plan the Fed is called upon to set the magnitude of its transfer to the Treasury to promote this mandate according to the Fed’s judgment.

Of course, some in Congress may try to pressure the Fed to provide the magnitude of transfer to the Treasury that they would like. But the same is true today of interest rates and Fed open-market operations: there are some in Congress who try to pressure the Fed to adjust interest rates or open-market operations to their liking. Nevertheless, despite such pressure from some members of Congress, the Fed has generally maintained its independence about adjusting interest rates and open-market operations. It seems equally likely that the Fed would maintain its independence in deciding whether to give a transfer to the Treasury, and if so, how much the transfer should be. Chapter 8

further discusses why stimulus without debt would not undermine the Fed’s current degree of independence from Congress and from the president.

Would an Amendment to the Federal Reserve Act Be Needed?

I have not been able to find a clear answer to the question of whether the Fed is prohibited under current law (the Federal Reserve Act or any other law) from (1) giving a large transfer to the Treasury; or (2) ordering a large amount of new Federal Reserve notes (equal to its transfer to the Treasury) to keep in its own vault and record as an asset on its balance sheet. Legal scholars may have written about it, but I have been unable to find such writings.

Ideally, before the next recession advocates of stimulus without debt will find a member of Congress who is willing to introduce a bill that would amend the Federal Reserve Act to explicitly permit the Fed to take the two actions listed above. Committee hearings on the bill would generate a debate on the stimulus-without-debt policy. If the next recession hits before Congress has considered the amendment, advocates should intensify their effort to have the bill introduced. In the meantime, I recommend that the Fed consult its own legal department and external legal scholars, and if the Fed concludes that there is no clear prohibition under current law, the Fed should go ahead and take actions (1) and (2) so that Congress can enact fiscal stimulus equal to the Fed’s transfer without borrowing by the Treasury and without weakening the Fed’s balance sheet.

If most legal scholars say the Fed isn’t prohibited from taking these two actions in a recession, the Fed faces a choice. It can wait for the next recession and then take action without seeking

approval from Congress. Or it can ask Congress now to amend the Federal Reserve Act to explicitly give the Fed permission to take these two actions in the next recession. On the other hand, if most legal scholars say that under current law the Fed is prohibited from so acting, then the Fed has no choice but to ask Congress to amend the Federal Reserve Act now if it wants the option of playing its key role in implementing stimulus without debt in the next recession.

Suppose the issue is ignored until the next recession. If the Fed chair asks the Federal Reserve’s Open Market Committee to authorize a large transfer to the Treasury for fiscal stimulus to combat the recession, it is likely that at least a minority of the FOMC will contend that the Fed is prohibited under current law. If a majority of the FOMC voted to do it and therefore a large transfer for fiscal stimulus was made (either by writing a check to the Treasury or by crediting the Treasury’s account at the Fed), it would probably be challenged in court. I don’t know whether a court can issue an injunction for the Treasury to return the transfer to the Fed or to hold the transfer rather than use it. Opponents of the Fed transfer might propose legislation that would order the Treasury to return the transfer to the Fed and prohibit the Fed from making a transfer in the future. Supporters of the Fed transfer in a recession might propose an amendment to the Federal Reserve Act permitting a transfer. In the meantime, Congress wouldn’t know whether any fiscal stimulus it considered enacting would be financed by the Fed’s transfer or would require borrowing by the Treasury. A legislator might vote for fiscal stimulus if it would not require borrowing by the Treasury, but vote against fiscal stimulus if it would require borrowing.

Clearly it would be better if Congress took action now to clarify the Fed’s power before the next recession. Stimulus-without-debt

advocates should work to find a member of Congress to introduce a bill now and get hearings held in the House or Senate committee that has jurisdiction. Committee hearings on the amendment would generate a debate on the stimulus-withoutdebt policy.

The bill would amend Section 14 of the Federal Reserve Act, currently entitled “Open-Market Operations.” The title of Section 14 would be changed to “Open-Market Operations and Transfers of Funds to the Treasury.” Section 14 currently has two subsections, (1) and (2). The amendment would add two new subsections, (3) and (4). Subsection (3) would give the Federal Open Market Committee the power to transfer funds to the Treasury to be used only for fiscal stimulus enacted by Congress in a recession or slow recovery or stagnant economy. Subsection (4) would require the Federal Reserve to order new Federal Reserve notes from the Bureau of Engraving and Printing equal to the amount of the Fed’s transfer to the Treasury, and require the Fed to keep these new notes in a Federal Reserve vault; these new notes would therefore be recorded as an asset on the Fed’s balance sheet. As explained earlier in my discussion of “worry about the Fed’s balance sheet,” subsection (4) would ensure that stimulus without debt leaves the Fed’s net worth (capital) unchanged on its balance sheet.

The political fate of the proposed amendment to the Federal Reserve Act would depend on the composition of the fiscal stimulus package that legislators expected. Discussions between members of the two parties should begin now over whether they can come to a tentative agreement over the composition of a fiscal stimulus package for the next recession. I urge both parties go back to the 2008 package that passed with bipartisan support and use it as a starting point to negotiate a tentative fiscal stimulus package for the next recession. In 2008, the

president was Republican, and Democrats were a majority in the House. With bipartisan support in Congress, a fiscal stimulus package was enacted that contained just two components: tax rebates to households (two-thirds of the package) and temporary tax incentives for business investment (one-third). In chapter 4 I’ll argue for making tax rebates the main component in a fiscal stimulus package, and in chapter 5 I’ll recommend also including in the package temporary tax incentives for business investment, temporary aid to state and local governments, and temporary federal spending on infrastructure maintenance projects, but excluding from the package components that favor the longterm agenda of one political party but not the other. By contrast, in 2009 and 2010 Democrats had a majority in the House and Senate and a Democrat in the White House, and shaped the composition of the fiscal stimulus package to largely favor their priorities. Democrats were able to the pass the fiscal stimulus bill, but Republicans voted unanimously against it.

Ideally, agreement on the composition of a fiscal stimulus package for the next recession and enactment of the proposed amendment to the Federal Reserve Act would both be achieved before the next recession. Unfortunately, Congress may not take action until the pressure of an actual recession is upon us. If some preliminary work has been done, however, it might be possible to move quickly as soon as the next recession hits. Under the pressure of recession, it might be possible for a bipartisan fiscal stimulus package to be negotiated. With both parties interested in avoiding higher federal debt, Congress might be willing to pass the amendment to the Federal Reserve Act. Finally, the Federal Reserve’s Open Market Committee might be willing, after learning about the contents of the negotiated fiscal stimulus package, to make the transfer to the Treasury that would enable the fiscal stimulus package to be implemented without any new borrowing by the Treasury.

Can’t Monetary Stimulus Overcome a Severe Recession?

Can’t monetary stimulus overcome a severe recession? As I emphasized earlier in this chapter, the Fed can and should act as a lender of last resort by aggressively performing financial rescues and unfreezing credit markets, and should cut interest rates to zero in order to help maintain some borrowing and spending by households and firms. But it is crucial to understand why cutting interest rates to zero cannot reverse the large plunge in aggregate demand that caused the severe recession.

In the first edition to his influential college economics textbook, with the experience of the Great Depression clearly in mind, future Nobel laureate Paul Samuelson (1948) gave the explanation shared by early Keynesians concerning the impotence of low interest rates to overcome a severe recession In a section entitled “The Inadequacies of Monetary Control of the Business Cycle,” Samuelson said that few economists (in 1948) thought the Federal Reserve could overcome a severe recession. Yes, the Fed can increase the supply of money and bank deposits, but the Fed can’t compel the money to be used to demand goods and services, thereby stimulating production and employment. In the middle of a depression, banks hesitate to make loans to business firms or households, so though the Fed can buy government bonds in the open market and thereby increase bank reserves, the banks will simply hold the reserves and there won’t be more borrowing and spending. Even if banks cut interest rates, questionnaire studies of businessmen’s behavior show that a fall in interest rates does not induce borrowing and spending on new machinery a in a severe recession when customer demand is weak, so business investment is likely to be unresponsive to the interest rate. The same is true about people’s decisions on how much to spend on consumption; a cut in interest rates won’t

induce nervous consumers to take on more debt in a deep recession. Samuelson therefore concluded that monetary policy is too weak to overcome a severe recession.

But doesn’t the “quantity theory of money” show that injecting more money into the economy must result in more spending on output, thereby stimulating production? Samuelson, like Keynes, rejected this “quantity theory.” He said that in the language of the quantity theory of money, the “velocity” of circulation of money does not remain constant. He invoked the analogy that you can lead a horse to water, but you can’t make it drink. The Fed can inject money into banks, but in a recession it can’t make pessimistic businessmen and consumers borrow and spend that money. The quantity of money in the economy will go up, but in a recession the velocity of circulation of money will go down, so spending and output will stay constant. Samuelson’s analysis, which I believe is still correct today, expresses the view of the Keynesian economists who dominated the economics profession in the 1940s, 1950s, and 1960s, such as Keynes and future Nobel Prize winners Tinbergen, Samuelson, Hicks, Klein, Tobin, Modigliani, and Solow; and current Keynesians such as Blinder and Nobel Prize winners Krugman, Stiglitz, Akerlof, and Shiller.

To explain most recessions, traditional Keynesians focus on aggregate demand for goods and services: if aggregate demand falls, output and employment will fall. Aggregate demand can fall for a variety of reasons, including the bursting of a stock market or housing bubble, or a retrenchment in spending by consumers or business managers in reaction to their own excessive spending and the running up of excessive debt, or a psychological shift of consumers or business managers from optimism to pessimism, and from confidence to anxiety. Standard monetary stimulus—a Fed injection of high-powered money into the banking system— can lower interest rates, but in a deep recession won’t induce most potential spenders to risk borrowing and spending because

loans must be paid back. Low interest rates can’t overcome a severe recession.

New Classical economists and even many New Keynesian economists differ from traditional Keynesians in key respects. New Classical economists contend that the economy will automatically recover quickly from recession as long as the central bank keeps the money supply from contracting; and that fiscal stimulus doesn’t work but does generate harmful government debt. New Keynesian economists are “Keynesian” in their view that keeping the money supply from contracting is not enough to generate a quick recovery from a deep recession. But prior to the 2008 recession, many New Keynesians believed that active standard monetary stimulus—cutting interest rates—would be sufficient to generate an adequate recovery from a deep recession and that fiscal stimulus was either unnecessary or ineffective. The experience of the 2008 recession caused some New Keynesians to recognize a basic tenet of traditional Keynesian economics as they came to realize that fiscal stimulus is essential for overcoming a deep recession (David Romer 2012).

The recent experience of the Great Recession provides strong evidence that when the Fed injects money into the economy by buying bonds and making loans, reserves sit idly in banks because anxious consumers and businesses are afraid to borrow. In their book on the 2008 recession, Mian and Sufi (2014) take issue with “the bank-lending view,” which holds that the key to recovery from recession is for the Fed to inject lots of money into banks in the hope that the banks will lend lots of money to consumers and businesses at low interest rates. They ask whether households and firms really want to borrow when the economy is depressed. They cite evidence from surveys of small businesses by the National Federation of Independent Businesses (NFIB), which asks business managers to indicate

their most important concern and offers choices such as poor sales, regulation and taxes, and financing and interest rates. The percentage of managers who put financing and interest rates as their main concern never rose above 5% from 2007 to 2009. This contradicts the view that small businesses were held back because they were unable to get financing. By contrast, from 2007 to 2009 the percentage of businesses citing poor sales as their top concern jumped from 10% to almost 35%. Businesses held back because of a sharp cut in customer demand.

Finally, even if monetary stimulus alone could overcome a severe recession, it would be better to rely mainly on tax rebates to households. There are at least two reasons for preferring tax rebates to cutting interest rates. First, tax rebates to households spread the increase in demand across all goods and services, roughly replicating the fall in demand across all goods and services during a recession. To respond to this demand, most firms would seek to rehire the same workers they had laid off. By contrast, monetary stimulus concentrates its direct effect on interest-sensitive sectors, a much narrower portion of the economy. Firms in the rest of the economy would not seek to rehire workers they had laid off. Thus, stimulus from tax rebates roughly restores the prerecession mix of goods, services, and jobs, whereas stimulus from cutting interest rates does not.

Second, relying on monetary stimulus alone means interest rates must be cut to zero and kept there for a long time. This puts a large and unfair burden on retirees who built up savings in their bank account during their work years, hoping that in retirement their bank would pay a normal interest rate. With stimulus from tax rebates restoring demand across all goods and services, interest rates would stay normal instead of being cut to zero. Chapter 9 further explains why it would be a mistake to rely on monetary stimulus to overcome a severe recession.

What Should Have Been Done in the Great Recession?

By the beginning of 2008 it was clear that the economy was falling into a recession. At that time, however, the severity of the recession was not widely anticipated. But by the middle of 2008, it was evident that the recession would be substantially worse than had been expected at the beginning of 2008. By the fall of 2008, it was clear that the economy was plunging into a severe recession. What fiscal/monetary stimulus was applied in 2008, 2009, and 2010? What should have been applied in 2008, 2009, and 2010?

Throughout this section I will assume, to simplify the calculation, that potential GDP—the GDP that would have occurred annually had there been no recession in these years—would have been $15,000 billion per year. In early 2008, a fiscal stimulus bill of about $150 billion passed Congress with bipartisan support and was signed by President Bush. It consisted primarily of a tax rebate for households ($100 billion), but also contained an investment bonus for business firms ($50 billion). With annual potential GDP equal to $15,000 billion, the fiscal stimulus was about 1% of potential GDP. In the remainder of this section, I will drop the word potential and simply write “1% of GDP.” The empirical studies that I examine in chapter 4 find that a plausible estimate of a tax-rebate multiplier in recession is 1.0; a taxrebate multiplier is less than a government-purchases multiplier because consumers save a portion of the rebate. Thus, this 1% of GDP tax rebate stimulus would be estimated to raise real GDP about 1%. With an output-to-unemployment estimate of two to one, this 1.0% increase in GDP would be estimated to reduce the unemployment rate 0.5%—for example, from 7.0% to 6.5%. Although enacted in early 2008, the tax rebate checks were not sent to households by the US Treasury until the summer of 2008.

Because the 2008 fiscal stimulus was 1% of GDP, it made the federal deficit 1% of GDP larger than it would have been without the fiscal stimulus—for example, if the deficit would have been 2% of GDP without the 1% of GDP fiscal stimulus, it would have been 3% with the fiscal stimulus.

By the summer of 2008, and certainly by the fall, it was clear that another, much larger fiscal stimulus would be needed in 2008. By summer, fiscal stimulus advocates (including me) were writing op-ed articles calling for the prompt enactment of a much larger stimulus. But in the second half of 2008 the president did not propose, nor did Congress enact, another fiscal stimulus. This was a policy failure of enormous magnitude. After the shocking bankruptcy of Lehman Brothers in September, attention was rightly focused on immediate rescues of financial firms to prevent a financial panic. What was unjustified, however, was the failure to even consider the enactment of a large fiscal stimulus in the second half of 2008.

The election of November 2008 meant that a pro-fiscalstimulus president would take office in mid-January, and profiscal-stimulus legislators would have a majority in both the House and the Senate in the new Congress. With remarkable speed, in early January the soon-to-be-president and the new Congress began developing a two-year fiscal stimulus, which was enacted into law in mid-February. The two-year stimulus would inject about $750 billion—$375 per year (2.5% of a potential GDP of $15,000 billion) into the economy in 2009 and another $375 billion (2.5% of GDP) in 2010. Over the three years 2008, 2009, and 2010, the fiscal stimulus was $900 billion ($150 + $375 + $375), 6% of GDP over three years, or an average of 2% of GDP per year. With a multiplier of 1.0, the stimulus would have raised GDP by 2% per year. With an output-to-unemployment estimate of two to one, the stimulus would have made the unemployment rate one percentage point lower than it otherwise

would have been—for example, at the end of 2010, 10% (its actual value) instead of 11%.

Thus, the fiscal stimulus implemented from 2008 through 2010, though large by historical standards, was too small to fully overcome the Great Recession. At the end of 2010, aggregate demand for goods and services was still well below potential output, the unemployment rate was still 9%, and consumer and business confidence was still well below normal. Yet the one-year fiscal stimulus legislation enacted in February 2008 was not renewed; nor was the two-year fiscal stimulus legislation enacted in February 2009 (the American Recovery and Reinvestment Act). Some additional fiscal stimulus was enacted and implemented in 2011 and 2012, but it was significantly smaller than the ARRA.

The $150 billion fiscal stimulus enacted in February 2008 consisted of tax rebate checks to households made in the summer of 2008 and bonus depreciation allowances for business firms on the 2008 tax return; there was no provision for anything beyond 2008. The $750 billion fiscal stimulus ($375 billion for 2009 and $375 for 2010) enacted in February 2009, the American Recovery and Reinvestment Act (ARRA), consisted of grants to state governments, tax cuts, and government purchases made primarily in two years, 2009 and 2010; there was no provision for any renewal of its components.

The lesson from the actual fiscal stimulus in the Great Recession is not that that fiscal stimulus doesn’t work, but rather that it was too small and phased out too quickly to overcome the severe recession. Republicans, who overwhelmingly opposed fiscal stimulus, won a majority in the House of Representatives in November 2010 and blocked renewal of ARRA components starting in January 2011. The Obama administration was able to get some new fiscal stimulus through Congress in 2011 and 2012—such as a temporary payroll tax cut—but the stimulus was too small to turn the recovery from sluggish to robust.

Suppose Congress and the president had enacted and implemented a fiscal stimulus consisting mainly of tax rebates that was three times as great—6% of potential GDP each year from 2008 to 2010. With a multiplier estimate of 1.0, the 6% of GDP fiscal stimulus would have raised GDP in each year 6% above what it otherwise would have been, and with an outputto-unemployment estimate of two to one, reduced the unemployment rate three percentage points below what it otherwise would have been each year—for example, at the end of 2010 the unemployment rate would have been 8% instead of 11%.

Suppose the entire fiscal stimulus had taken the form of tax rebates. With 300 million people, $450 billion (3% of GDP) each June and December (6% of GDP for the year) would have supported a rebate of $1,500 per person (for example, $2,000 per adult, $1,000 per child) each June and December, so twice a year a family of two adults and two children would have received a $6,000 rebate check.

Why wasn’t a 6% of GDP fiscal stimulus enacted in each year from 2008 through 2010? In those years no one considered proposing a transfer from the Fed to the Treasury—a key element of stimulus without debt. It was therefore assumed that a 6% of GDP fiscal stimulus each year would raise government debt by 6% of GDP each year. With debt already rising sharply as a percentage of GDP due to the recession itself, many opponents of fiscal stimulus voiced alarm about making government debt larger, and even many supporters of fiscal stimulus worried about larger debt.

Suppose, however, that prior to 2008, stimulus without debt had been proposed by economists and that Congress had amended the Federal Reserve Act to permit the Federal Reserve to give a transfer to the Treasury for fiscal stimulus in a recession. As the economy plunged into severe recession in 2008, Congress might have been willing to enact fiscal stimulus equal to 6% of

GDP each year for three years provided the Fed was willing to provide a transfer to the Treasury equal to 6% of GDP each year for three years. If the Fed decided to make the 6% of GDP transfer each year from 2008 to 2010, and Congress enacted the 6% fiscal stimulus each year from 2008 to 2010, the unemployment rate at the end of 2010 might have been 8%, three points below what it would have been without any fiscal stimulus (11%), and two points below its actual value (10%) which resulted from the actual 2% of GDP fiscal stimulus (the average of 1% in 2008, 2.5% in 2009, and 2.5% in 2010).

By summer of 2010 it was clear that despite the 2% of GDP fiscal stimulus, the recovery was still not strong enough. Prostimulus legislators still had majorities in House and Senate. But these pro-stimulus legislators were afraid of making government debt still larger, so they didn’t go forward. If stimulus without debt had been available, these pro-stimulus legislators might have passed another two-year fiscal stimulus for 2011 and 2012. So with stimulus without debt, we might have had a much larger fiscal stimulus for another two years. The stimulus would have strengthened the recovery and we might have reached 5% unemployment two years earlier than we did (2013 instead of 2015). Thus, stimulus without debt is a means of getting a larger and/ or longer fiscal stimulus passed by Congress in a recession or a slow recovery.

Would Stimulus without Debt Increase Government Deficits?

Under the stimulus-without-debt policy, the government deficit would not increase because the government’s Treasury would receive revenue from the Federal Reserve equal to the fiscal stimulus. For example, suppose the fiscal stimulus consists of $900

billion of spending on tax rebates and other programs; then the Treasury would receive $900 billion in revenue from the Fed, so the increase in the Treasury’s total revenue ($900 billion) would equal the increase in its spending. This is the same budget treatment given by state governments to receipt of transfers from the federal government; the state government adds federal transfers received to state tax revenue to obtain total revenue, which is then compared to total state government spending (outlays) to determine the state government’s deficit.

But isn’t fiscal stimulus the same thing as an increase in the deficit? No, it isn’t. Fiscal stimulus is an increase in government spending and/or a cut in taxes because both of these raise aggregate demand for goods and services. A simple definition of fiscal stimulus is the difference between government spending and tax revenue. If government spending (at a given level of GDP) increases, aggregate demand for goods and services (at that level of GDP) increases; if tax revenue (at a given level of GDP) decreases, aggregate demand (at that level of GDP) increases. This definition is too simple because an X-dollar increase in government purchases of goods and services increases aggregate demand more than an X-dollar increase in government transfers because recipients save a portion of transfers that they receive; for the same reason, an X-dollar decrease in tax revenue causes a smaller increase in aggregate demand than an X-dollar increase in purchases. These complications need to be kept in mind when using my simple definition.

The government deficit is the difference between government spending and total revenue, not just tax revenue. In particular, if the government receives transfers (grants) from any other entity, the transfers received by the government increase the government’s total revenue. For example, suppose a state government spends $250 billion, collects $200 billion in taxes, and receives $50 billion in grants (transfers) from the federal

government. Then its deficit is $0 even though its spending is $50 billion greater than its tax revenue. This state government does not have to borrow; its deficit is $0 and there is no increase in its debt. If it is under a balanced budget requirement by law, it has met the requirement.

Suppose initially the federal government spends $3,000 billion, collects $3,000 billion in tax revenue, and receives no transfer from the Federal Reserve. Under my simple definition of fiscal stimulus, its fiscal stimulus is $0. Its deficit is also $0. Now suppose its spending is raised to $3,900 billion while its tax revenue remains $3,000 billion, so its fiscal stimulus is $900 billion. If it still receives no transfer from the Fed, its deficit is also $900 billion, but if it receives a transfer of $900 billion from the Fed, its deficit is $0. Thus, fiscal stimulus can be increased without increasing the deficit if the stimulus is accompanied by an equal increase in transfers received from the Federal Reserve.

Chapter 4

Do Tax Rebates Work in a Recession?

The most recent uses of tax rebates to households in the United States to combat a recession were in the summer of 2001 and the summer of 2008. Several studies published in the year following each rebate claimed that the rebates did not work. But in my view the study using the best methodology and the best data to analyze the impact of the 2001 tax rebate was coauthored by Johnson, Parker, and Souleles (2006) and published in a topranked, peer-refereed journal, the American Economic Review, in its December 2006 issue, five years after the 2001 rebate occurred; it estimated that consumers spent about one-third of the rebate within three months and about two-thirds of the rebate within six months. The study using the best methodology and the best data to analyze the impact of the 2008 tax rebate, was published in the American Economic Review in its October 2013 issue about five years after the 2008 rebate occurred and was, coauthored by Parker, Souleles, Johnson, and McClelland (2013); it estimated a slightly larger and faster response. Another study coauthored by Broda and Parker (2014) and published in the Journal of Monetary Economics in its fall 2014 issue estimated a response

similar to the two other studies. The conclusion from these three studies is that the tax rebates worked: the average household recipient spent about one-third of the rebate within three months and about two-thirds within six months. This chapter will review the major studies of the 2001 and 2008 tax rebates, explain and contrast the methodologies and data in the studies, and draw policy conclusions.

Do Tax Rebates to Households in a Recession Actually Work?

At first glance it seems commonsensical that the consumption spending of a typical household varies directly with its current disposable income, even if its spending also depends on other factors. Because the consumption spending of a typical household is a high percentage of its current disposable income, at first glance it also seems commonsensical that if a typical household receives a tax rebate in a recession, within a year it will spend a significant percentage of its rebate. Some economists, however, are skeptical that tax rebates to households in a recession will be spent during the recession. These economists contend that because households know that the rebates will stop when the recession ends, they will save the rebates during the recession.

Other economists, including me, however, find it plausible that the percentage of a recession tax rebate that the typical household spends within a year is substantially less than 100% but also substantially greater than 0%. Most economists agree that empirical research based on study of the actual response of actual consumers to actual tax rebates in a recession is needed to determine how effective tax rebates are in stimulating consumer spending during a recession. The US Treasury mailed out one round of tax rebate checks to households in the 2001 recession

and one round in the 2008 recession. This chapter will examine the major empirical studies of these two episodes.

It will be useful at the outset to provide a big-picture summary. Details will be supplied in the rest of this chapter. The effectiveness of the summer 2001 tax rebate was quickly thrown into doubt by a consumer survey, conducted and interpreted by two respected professors of economics at the University of Michigan, Mathew Shapiro and Joel Slemrod, who asked a sample of consumers what they planned to do with their rebate. In fall 2001 the coauthors of the survey reported that “only” 22 percent of consumers said they planned to “mostly spend” their rebate, and these authors communicated to the media that their survey showed that the tax rebates didn’t work. Besides generating media attention and publicity in the fall of 2001, they published an article with their survey results and interpretation in the American Economic Review (Shapiro and Slemrod 2003a) and another article with additional analysis of their survey in a volume on tax policy and the economy (Shapiro and Slemrod 2003b). Their survey, study, and interpretation influenced many to conclude that tax rebates didn’t work.

It took five years after the Shapiro-Slemrod fall 2001 consumer survey before another study, coauthored by three other respected economists, David Johnson, Jonathan Parker, and Nicholas Souleles (2006), was published in the American Economic Review in late 2006, using data on actual expenditures reported by individual consumers following the 2001 rebate rather than a survey of consumer intentions, and concluded that consumers had in fact spent about one-third of their rebate dollars within three months of receiving it and about two-thirds of their rebate dollars within six months—in other words, the tax rebates of 2001 had in fact been very effective in boosting consumer spending above what it otherwise would have been in the halfyear following their payment to households.

The initial claim that the summer 2008 tax rebates were ineffective in combating the 2008 recession came from two influential professors of economics, Martin Feldstein and John Taylor, who separately and independently published op-ed articles in the Wall Street Journal concluding that the 2008 tax rebates had been ineffective (Feldstein 2008; Taylor 2008), and presented their analysis at the January 2009 annual conference of the American Economic Association (AEA), which received substantial media coverage during the period when Congress and the new president were deciding the composition of a fiscal stimulus package to combat the Great Recession. Their articles based on their presentations were published in the May 2009 Papers and Proceedings of the AEA conference (Feldstein 2009; Taylor 2009). Their op-ed articles and presentations had a significant impact on the view of policymakers and the public. It took three years before two other economics professors, my colleague Kenneth Lewis and I (Lewis and Seidman 2012), published a detailed analysis and rebuttal of the articles by Feldstein and Taylor in an economics journal that has a much smaller readership and gets much less media coverage.

At the same time, the two professors of economics who conducted the consumer survey in fall 2001, Shapiro and Slemrod, conducted a consumer survey in fall 2008 and presented their analysis at the same January 2009 conference of the AEA. Their article (Shapiro and Slemrod 2009) based on their presentation was also published in May 2009 AEA Papers and Proceedings. They also published a second article (Sahm, Shapiro, and Slemrod 2010) on the 2008 rebate in an annual volume on tax policy and the economy in 2010, joined by coauthor Claudia Sahm. The featured headline from both of their articles was that their survey showed that “only about a fifth” of consumers said they planned to “mostly spend” their rebate, and these authors communicated to the media that once again, as in 2001, their survey showed that tax rebates didn’t work.

Once again, it was five years after the 2008 rebates were mailed to households before another study, conducted and interpreted by the same professors who had examined actual expenditures reported by consumers following the 2001 rebate, Parker, Souleles, Johnson, with a new coauthor McClelland, was published in the American Economic Review in October 2013. It estimated that the response of consumers to the 2008 rebate was slightly larger and faster than they had estimated for the 2001 rebate. They concluded that tax rebates were very effective in promptly raising consumer spending. It took six years for a study by Broda and Parker using different data to be published in the Journal of Monetary Economics in fall 2014; it estimated a similar magnitude for the impact of the 2008 rebate on consumer spending.

Although the recovery from the Great Recession of 2008 was very slow, no second tax rebate was issued after 2008. There were, however, two other policies that were used from 2009 through 2012 that at first glance seem similar to tax rebates and were viewed by some policymakers as replacements for the 2008 tax rebate. In 2009 and 2010, Congress enacted a “Making Work Pay” tax credit for employees ($400 for singles and $800 for married couples) that was implemented by requiring employers to reduce federal income tax withholding according to a schedule set by Congress (Seidman 2009). In 2011 and 2012, Congress replaced the Making Work Pay credit with a temporary payroll tax cut for employees from 6.2% to 4.2%, which was implemented by requiring employers to reduce federal payroll tax withholding according to schedule set by Congress (the Social Security Trust Fund would be reimbursed by general revenue so that future Social Security benefits of these employees would be unaffected). At the end of this chapter, I will compare the method of cutting withholding (either for federal income tax or federal payroll tax) to mailing out tax rebate checks to households by the US Treasury.

The 2001 Tax Rebate

Prior to the onset of recession in late 2000, Republican presidential candidate George W. Bush in early 2000 proposed a permanent across-the-board cut in income tax rates for the same reason that candidate Ronald Reagan had done in 1980: conservative philosophy and supply-side economics. Like Reagan, Bush believed in lower taxes and less government domestic spending. Like Reagan, Bush accepted supply-side economics, which held that high marginal tax rates were discouraging people from supplying labor and saving, thereby holding back the pace of economic growth and of the economy. During the 2000 campaign, Democrats opposed Bush’s permanent tax cut proposal.

But in early 2001 there was a new consideration: a recession, precipitated by the bursting of the stock market bubble in 2000. Democrats continued to reject the reasons Bush gave for his permanent across-the-board cut in income tax rates. But some Democrats instead supported a temporary tax rebate with equal dollar benefits for households of all incomes to help them cope with the recession and boost demand for goods and services to combat the recession.

On January 28, 2001, my op-ed article was published in the Philadelphia Inquirer with this title: “In a Recession, Think Tax Rebates, Not Across-the-Board Cuts in Taxes.” My op-ed began by reminding readers that a tax rebate for households had been enacted with bipartisan support during the 1975 recession to stimulate consumer spending. President Ford signed the Tax Reduction Act of 1975 in January. Its key element was a 10% rebate of each household’s 1974 personal income tax up to a maximum of $200 per household. I urged the enactment of a similar tax rebate in 2001.

In fact, the 2001 Bush tax-rate cut proposal, while originally not containing a tax rebate, contained one element that could

be implemented through a tax rebate. Under the income tax schedule then in effect, the tax rate that applied to the first dollars of taxable income was 15%. Although the Bush plan emphasized the cut in the top marginal tax rates, it also contained a proposal to create a new 10% bracket that would apply to the first $12,000 of taxable income for a couple filing jointly, and the first $6,000 for a single person; thereafter, the household would enter the 15% tax bracket. This cut of five percentage points (15% to 10%) on the first $12,000 of taxable income for a couple meant a $600 tax cut; on the first $6,000 for a single person, a $300 tax cut. Taxpayers of all incomes pay the first-bracket rate on their first dollars of taxable income, so all couples with taxable income above $12,000 would receive an equal dollar tax cut—$600 under the Bush plan (and all singles with taxable income above $6,000 would receive a $300 tax cut). This one element of the Bush plan appealed to many Democrats.

The final tax act, passed by Congress near the end of May, reflected the fact that the Republicans controlled both Congress and the White House. The Democrats proposal to enact an additional one-time check to people who paid payroll tax as well as income tax was omitted. However, the president’s five-percentagepoint cut on the first $12,000 (for a couple), instead of being implemented through small changes in withholding rates and a final adjustment on the 1040 tax return due April 15, 2002, would be implemented more promptly, just as the Democrats proposed: tax rebate checks would be mailed out by the US Treasury quickly (between July and September 2001), $600 per couple ($300 for an individual). On June 7, 2001, President Bush signed the tax bill into law. In early July, millions of taxpayers received a “Dear Taxpayer” letter from the US Treasury saying that they would receive a check for $600 (couple) or $300 (single) due to action by Congress and the president. The Treasury did not mail out all the checks on the same day. Instead, a fraction

of the checks were mailed out each week for three months. Each recipient’s Social Security number determined the week the recipient received the check. (The tax rebate of 2001 is more fully described in Seidman 2003.)

In the summer of 2001, real GDP growth stayed below normal, the stock market continued to fall, and the unemployment rate continued to rise, so some of us came to the conclusion that preparation should begin immediately for a second round of tax rebates in the fall. For example, my letter to the editor appeared in the New York Times on September 1, 2001, with the title “The Rebate Helps. Do It Again.” However, momentum for repeating the rebate was stopped in its tracks by the announcement by two respected economists at the University of Michigan, Mathew Shapiro and Joel Slemrod, that results from their survey of consumers indicated that the rebates were ineffective because only 22% of recipients indicated the rebate dollars would be mostly spent.

Shapiro and Slemrod’s 2001 Consumer Survey

In the fall of 2001, Shapiro and Slemrod released results to the media of their survey of roughly 1,500 consumers who had received the 2001 tax rebate that summer. They subsequently published two full-length articles on their survey of the 2001 rebate, the first in a top-ranked economics journal (Shapiro and Slemrod 2003a), the second in a respected annual volume on tax policy and the economy (Shapiro and Slemrod 2003b). Their results received substantial top media coverage beginning in the fall of 2001 that definitely influenced the debate in Congress against enacting a second rebate in late 2001 or in 2002. They asked survey questions of households in August and September

about their plans for the tax rebate mailed by the US Treasury in July, August, and September, and reported that only 22% said they “would mostly increase spending”; most respondents said they would to use the rebate either to pay down debt or to save. “Only” was the word the authors emphasized in their report, and “only” was the word the media focused on. The report and its coverage conveyed the message to the public that the rebate didn’t work. They soon wrote up their results in a National Bureau of Economic Research (NBER) working paper, and that paper, “Consumer Response to Tax Rebates,” was subsequently published in the American Economic Review (Shapiro and Slemrod 2003a).

In their survey they asked this question: “Thinking about your family’s financial situation this year, will the tax rebate lead you mostly to increase spending, mostly to increase saving, or mostly to pay off debt?” Note the phrase “Thinking about your (family’s) financial situation.” Why did Shapiro and Slemrod insert such a phrase? Why tell the respondent what he or she should be thinking about in order to decide what to do with the rebate? If you’re told to think about your financial situation, you’re likely to think, “I really want to buy some badly needed goods and services, but thinking about my financial situation makes me realize I better instead save or pay off debt.” The introductory phrase may well have influenced some respondents to answer either “mostly to increase saving” or “mostly to increase debt.” Suppose instead the phrase had been “Thinking about the goods and services your family badly needs . . . ” Surely that phrase would have influenced some respondents to answer “mostly increase spending.” The best way to be neutral would have been to have no phrase at all.

The second problem with their wording is the time frame. The respondent is asked to think about the family’s financial situation “this year,” but the sentence does not end with a specific

time frame such as “over the next month” or “over the next two months” or “by the end of this year” or “over the next twelve months.” The respondent is given no explicit guidance about the time frame. It seems likely that many respondents would read the phrase “this year,” and assume the question meant, “What will you do by the end of this calendar year?” The US Treasury mailed the rebates out every week from late July to late September, so the average recipient received the rebate in late August. After receiving the rebate, the recipient had four months left until the end of the calendar year. Thus, it seems likely that the average recipient would interpret the question as, “What will you mostly do with the rebate in the next four months?”

The third problem with their question is that it does not ask, “What percentage or fraction of the rebate do you plan to spend this year?” In response to the release by Shapiro and Slemrod of their survey results in the fall of 2001, Seidman and Lewis (2002) pointed out that the survey did not measure the percentage of rebate dollars spent on consumption (the marginal propensity to consume rebate dollars). They noted that Shapiro and Slemrod did not ask the household what percentage or fraction of its additional tax-home pay it intended to spend. If they had asked about the percentage or fraction, they would have received an answer about the respondent’s intended marginal propensity to consume (MPC).

The answer to their question did not give the respondents’ intended MPC. Consider a hypothetical example. Suppose every household intended to spend 40%, save 10%, and use 50% to repay debt. Then 0% would answer that they intended to spend most of it. Yet in this example, the percentage of additional takehome pay households intended to spend would be 40%, not 0%; the MPC would be 40%, not 0%. Because the percentage was not asked, the study did not obtain information on the percentage of rebate dollars that households intended to spend (the intended MPC). I made this point in Seidman (2003).

In their American Economic Review article, Shapiro and Slemrod (2003a) gave readers the impression that they had measured the MPC. They said that the 22% figure was well below what most other research would suggest for the propensity to consume for increments to income. In their AER article, Shapiro and Slemrod did not alert readers that their 22% did not mean that households intended to spend 22% of the rebate. They did not warn readers that their survey had not obtained the MPC. Recall that the Seidman and Lewis article published in 2002 emphasized that Shapiro and Slemrod’s 22%—the percentage who said they would mostly spend the rebate—was not the MPC out of the rebate.

In their second article on the 2001 rebate, Shapiro and Slemrod (2003b) acknowledged this point and conceded that that their 22% was not the MPC. They included a section with the title “Converting Survey Responses into an Aggregate MPC.” They conceded that the aggregate MPC for their sample was not obtained directly from their survey. Instead, their survey provided self-reported estimates of the fraction of people who would either mostly spend the rebate or mostly save it, either by adding it to assets or repaying debt. They said they decided not to ask survey participants for their MPC because that might be “too complicated.” As a consequence of that decision, their survey was unable to provide an answer to the important question: What fraction of the total rebate dollars was spent?

Having made that decision, they tried to persuade their readers that it was still possible to determine the aggregate MPC by making deductions based on “plausible assumptions.” They wrote that they could infer the MPC by making a few assumptions about what range of individual MPCs corresponds to mostly spending or mostly saving and the distribution of those individual MPCs. They mentioned the Seidman-Lewis (2002) numerical example above but called it extreme and misleading. Yet with their assumptions, they computed an aggregate MPC of 36%, just a few points below the MPC of 40% in the Seidman-Lewis example. Their statement

that 36% of the rebate was spent is therefore not a direct finding from their survey, but a deduction based on assumptions and a complex translation method that they called “plausible.”

Let me now summarize my three objections to the wording of their question and what can be learned from their survey. First, they discouraged respondents from answering “mostly spend” by introducing the phrase “Thinking about your (family’s) financial situation,” so it is likely that the percentage who reported that they would “mostly spend” was less than the percentage who really intended to “mostly spend.” Second, they did not specify the time frame; because they used the phrase “this year,” it seems likely that with checks received in the summer, the typical respondent assumed the time frame was the rest of the calendar year—roughly four months (because rebates were mailed by the Treasury from late July through late September). Third, they did not ask what percentage or fraction of the rebate dollars the respondent intended to spend, so they had to make assumptions that would enable them to translate the answers to their questions into the MPC out of the rebate—the percentage or fraction of the rebate dollars respondents intended to spend over the next four months. The translation assumptions they made led them to an estimate of 36% for the four-month MPC, but other translation assumptions would have led to other estimates. Given these important shortcomings, my interpretation is that their survey results imply at least 40% of the rebate dollars would be spent within four months.

Johnson, Parker, and Souleles’ Study of the 2001 Rebate

It took over five years from the summer of 2001 when tax rebates were mailed to households until the Johnson, Parker, and Souleles (JPS) article was published in the December 2006

issue of the American Economic Review with the title “Household Expenditure and the Income Tax Rebates of 2001.” In contrast to Shapiro and Slemrod, who asked roughly 1,500 individuals what they planned to do with their rebates, JPS used the Consumer Expenditure Survey conducted by the US Bureau of Labor Statistics (BLS), in which about 13,000 individuals reported estimates of what they had spent on various goods and services in the preceding three months.

JPS began their article by explaining that a fraction of the rebate checks were mailed out each week over three months, which enabled them to estimate the change in household expenditures due to rebate receipt by comparing the expenditures of households that received rebates in different weeks. Their study took advantage of the fact that the timing of the mailing of each rebate was based on the second-to-last digit of the Social Security number of the tax filer who received it, a digit that is effectively randomly assigned.

JPS explained that the regular consumer expenditure (CE) data did not have enough information for a full analysis of the impact of tax rebates on spending because the CE survey did not record the timing of taxes and transfers within the year, nor did it record the Social Security numbers of household tax files. But immediately after the passage of the 2001 Tax Act, university economists Parker and Souleles teamed up with BLS economist Johnson and with his cooperation and participation as well as other BLS and government staff, a special module of questions about the tax rebates was added to the CE survey, thereby making the study possible. This module asked households about the timing and amount of each rebate check they received. The module was included in the survey from shortly after the rebate mailing began until the end of 2001. The JPS paper was the first to use the new tax rebate module and exploit the randomized timing of the rebates in the CE survey.

It took five years for Parker, Souleles, and Johnson to embark on their study in 2001, develop their module, obtain data from CE households, analyze the data, write their paper, submit it to the American Economic Review, wait for referees to review it, respond to reviewers, have their paper accepted, and then finally see it appear in print in the December 2006 issue. From the fall of 2001 to December 2006, the Shapiro and Slemrod study had left economists and policy makers with the impression that the 2001 rebate had been ineffective. Finally, in December 2006, the Johnson, Parker, and Souleles study showed economists and policymakers that, on the contrary, it was very likely that the 2001 rebate had in fact been very effective.

JPS reported that the average household in their sample spent about one-third of its rebate within three months of receiving it, and about two-thirds within six months. They also reported that households with low levels of liquid assets or low income spent significantly more of the rebate than the average household. They ran regressions with the individual household’s consumption as the dependent variable and the amount of that household’s rebate as the key independent variable. They found a statistically significant short-run impact of the rebate on consumer spending. Moreover, they said that the estimated effects were economically significant, implying a substantial increase in aggregate consumption spending. In their conclusion, they said their study found significant evidence that households spent much of their rebates shortly after they arrived and that the rebates generated a substantial stimulus to the national economy in 2001, helping to end the recession because the rebates directly (ignoring multiplier effects) increased total personal consumption expenditure by nearly 1.0% in the third quarter of 2001 and 0.5% in the fourth quarter.

The Johnson, Parker, Souleles study, finally published at the end of 2006, reversed the conventional wisdom that the Shapiro

and Slemrod study had established five years earlier in the fall of 2001, and the reversal came just in time because an economic storm was brewing in 2007 in the US housing market that would soon plunge the United States into its worst recession since the 1930s.

The 2008 Tax Rebate

After the bursting of the housing market bubble in 2007, the US economy began to fall into recession. In early 2008, surprisingly, tax rebates were put on the front burner in Congress. It’s not clear why. As we’ve seen, soon after the 2001 rebate checks had been sent out, Shapiro and Slemrod obtained impressive media coverage and publicity for their claim that the tax rebate failed. By contrast, Johnson, Parker, and Souleles obtained little publicity for their study concluding that the 2001 rebate had worked. Maybe some members of Congress remembered that they had passed a tax rebate in 2001 and that common sense told them that writing checks to consumers would raise consumer spending. In February 2008, with the bipartisan support of a Republican president (George W. Bush) and a Democratic Speaker of the House (Nancy Pelosi), a large bipartisan majority in Congress voted overwhelmingly to enact the Economic Stimulus Act of 2008, which devoted two-thirds of its funds to a tax rebate for households. The estimated total expenditure under the act was roughly $150 billion, and the estimated expenditure for tax rebates was roughly $100 billion.

Under the tax rebate, single individuals received between $300 and $600, and married couples received between $600 and $1,200. Those with dependent children received an additional $300 per child. A broad group of households—those with an income tax liability or those with at least $3,000

of qualifying income—were eligible for the 2008 rebate. Qualifying income included forms of income that are not fully taxable such as Social Security benefits. The rebate was phased out at higher income levels by reducing the payment by 5% of any income above $75,000 for single filers and $150,000 for joint filers.

The Treasury distributed the rebates electronically (direct deposit) if it had taxpayer personal bank account information. Otherwise it mailed a paper check. Conditional on the form of the payment, the exact timing of the payment depended on the recipient’s Social Security number. The payments, in particular the electronic fund transfers (EFTs), were distributed quickly. For tax returns processed by the IRS by April 15 for which the IRS had a private electronic routing number (not the number of the tax preparation firm) rebates were distributed via direct deposit by May 16 (i.e., over a three-week period). The distribution of rebates via paper check began in the final week of the direct deposit distribution and was completed by July 11 (a nineweek period). Before the payments, all eligible households were sent a letter from the US Treasury stating the amount of their forthcoming rebate. The total amount of rebate income paid out by the Treasury in 2008 was April, $2 billion; May, $48 billion; June, $28 billion; July, $14 billion; August–December, $4 billion, for a total of $96 billion.

Technically, the rebate was a credit for tax year 2008, but to expedite the payments, the rebate amount was estimated (in terms of eligibility and for the purpose of calculating the high-income phaseout) using 2007 taxable income. If actual income in a 2008 tax return implied a higher rebate value, then the difference was paid out to the individual (or applied to any tax liabilities from the 2008 return). Individuals who were “overpaid” on the basis of their 2007 income did not have to repay the excess amount of their rebate.

The 2008 rebates differed from the 2001 rebates in several ways. In 2001, the tax rebates were “advanced payments” of $300 for singles and $600 for couples that corresponded to the benefit from a new 10% income bracket. Hence, the 2001 rebates were linked to tax liabilities and for the most part went only to individuals with tax liabilities. The 2001 rebates went to a smaller fraction of the population, were smaller in aggregate relative to the size of the economy, and were not phased out for high-income individuals. The 2001 rebates were distributed by check over a ten-week period, so their disbursement was more spread out over time than in 2008. As in 2008, the paper checks in 2001 were mailed out on the basis of the recipient’s Social Security number. These 2008 stimulus payments were large and were disbursed quite quickly. They amounted to 8.7% of 2008 federal personal tax payments. Most of the payments were disbursed in May and June.

Taylor and Feldstein’s Wall Street Journal Op-Ed Articles

During the Great Recession, the professional economist who probably did more than any other economist to try to discredit fiscal stimulus in general, and tax rebates in particular, was John Taylor of Stanford. Taylor wrote widely read op-ed articles in the Wall Street Journal, published articles in economics and policy journals, gave quotes to the media, appeared on TV, and spoke at conferences. Taylor certainly had help from other economists, including Martin Feldstein of Harvard and Shapiro and Slemrod of the University of Michigan. But in my judgment Taylor probably had the greatest impact in 2008–2009.

The rebates were mailed out in the summer of 2008, and by the fall Feldstein and Taylor had separately and independently

published Wall Street Journal op-eds asserting that the summer and fall aggregate data for the US economy showed that the rebates had failed to stimulate consumer spending. Each asserted that aggregate time-series data from the US Bureau of Economic Analysis’s National Income and Product Accounts before and after the rebate proved that the rebate failed. At the January 2009 annual conference of the AEA, Feldstein and Taylor each presented lengthier papers claiming that the 2008 rebates had failed and argued that it would be a serious mistake to enact another tax rebate to try to combat the deepening 2009 recession. Their presentations received substantial media coverage. They published articles in May 2009, based on their January 2009 presentation, in the annual Papers and Proceedings of the AEA. Their articles and presentations were one reason that, despite the deep recession and slow recovery from 2009 through 2012, Congress did not authorize the US Treasury to mail out any more tax rebates to households.

Before discussing Feldstein and Taylor, I should note how a rebate is supposed to work. After receiving a rebate check from the US Treasury, a household deposits the check and the household’s savings initially increase by the amount of the rebate. Gradually, the household spends more than it otherwise would have. Thus, immediately after a household receives a rebate check, there is a spike in saving, not a spike in spending, relative to what it would have been the case without the rebate. The key issue is the time path of consumption spending following receipt of the rebate compared to what spending would have been—in particular, the spending differential during the year following the receipt of the rebate.

It is important to note that advocates of tax rebates expect recipients to use the rebate partly to pay down debt, partly to save, and partly to spend. A crucial feature of the rebate is that it lets households do some additional spending while also reducing

their debt. This is in sharp contrast to standard monetary stimulus, which lowers interest rates to induce households to spend more by borrowing—by increasing their debt. It is hard to get households that have taken on excessive debt in the preceding boom to borrow more. Thus, a crucial difference between tax rebates and standard monetary policy is that rebates enable households to spend more while reducing their debt, whereas standard monetary policy depends on debt-burdened households being willing to take on still more debt in order to spend more.

To assess the impact of any policy, a comparison is required between what actually happened after the policy was implemented, and what would have happened if the policy had not been implemented. What would have happened can only be estimated—it cannot be known with certainty. Yet Feldstein and Taylor claimed that before-and-after data prove conclusively that the rebate failed. In his WSJ article, published August 6, 2008, Feldstein asserted that the increase in consumption due to the rebate was only 15% of the rebate, a conclusion he reached simply by examining data before and after the rebate. He said the tax rebates of $78 billion arrived in the second quarter of the year, but government data showed that the level of consumer outlays only rose by an “extra” $12 billion, or 15% of the rebates, so the rest went into savings, including the paying down of debt.

Notice the misleading word “extra” preceding “$12 billion.” What did Feldstein mean by “extra?” He meant that consumer outlays were $12 billion more in the second quarter than they were in the first quarter. He implicitly made the entirely unjustified assumption that, if there had been no rebate, consumer outlays in the second quarter would have been the same as in the first quarter. But his assumption (not “fact”) that outlays would have been the same in the two quarters (had there been no rebate) was implausible because, in the second quarter, house prices, stock market price indices, and the University of

Michigan’s index of consumer sentiment all plunged, and Bear Stearns nearly failed in March, rattling financial markets. These dramatic second-quarter negative economic events might well have caused personal outlays to shrink (had there been no rebate). If so, then Feldstein’s $12 billion is a substantial underestimate of how much the rebate raised consumption above what it otherwise would have been, given these negative events. For example, if consumption outlays would have been $13 billion lower in the second quarter than the first quarter due to these negative events (had there been no rebate), then the rebate caused consumption outlays to be $25 ($13 + $12) billion higher than what they would have been in the second quarter (had there be no rebate).

In his WSJ article, November 25, 2008, Taylor addressed the impact of the mid-2008 tax rebate to households by presenting a chart that he claimed showed the tax rebate didn’t work. The horizontal axis of the chart was the months from January 2007 to October 2008. For each month two points were plotted: the higher point showed household disposable income and the lower point showed household consumption. From January 2007 to April 2008 the disposable income curve and the consumption curve grew slowly in parallel, but in May–July 2008 the disposable income curve jumped up, reflecting the payment of tax rebates in these three months, but the consumption curve did not jump up. Taylor asked readers to observe that consumption showed no noticeable increase at the time of the rebate. Taylor concluded from his chart that the rebate did little or nothing to stimulate consumption.

Taylor therefore claimed that actual data from May through July proved the rebate didn’t work. But what Taylor’s chart of actual data didn’t show is what would have happened to consumption after April 2008 had there been no rebate. In mid-2008, several other influences already mentioned—the plunge in house

and stock prices, the unprecedented high level of consumer debt, and the fall in the consumer confidence index—would likely have reduced consumption after April. Yet consumption didn’t fall until September. It is therefore plausible that the rebate kept consumption from falling from May until September when it otherwise would have fallen.

Christina Romer, chair of President Obama’s Council of Economic Advisers in 2009 and 2010, provided a critique of Taylor’s WSJ article on the 2008 tax rebate in a 2011 public lecture. She pointed out that Taylor’s analysis failed to consider what besides the rebate was going on at the time. The tax rebate was enacted because Congress realized the economy was heading downward and consumption was likely to fall. The subprime mortgage crisis had taken hold. House prices were tumbling. Mortgage lenders were in deep trouble. Economists worried that consumption was about to plummet. For most families, their home is their main asset. When house prices fall, people are poorer, and so tend to cut back on their spending. Contrary to the claims by Feldstein and Taylor, Romer contended that the fact that consumption held steady around the time of the tax rebate shows just how well it was working: it kept consumption up for a while despite the strong downdraft of falling house prices. You can’t deduce the effect of a tax rebate or some other policy just by looking at outcomes. You have to think hard about what else was going on, and where the economy was heading in the absence of policy. Taylor and Feldstein didn’t.

Lewis and Seidman’s Critique of Taylor and Feldstein

After asserting in their Wall Street Journal op-eds that the 2008 rebate failed, Taylor and Feldstein turned to the standard

regression method and report results in their 2009 AER articles. Both Taylor and Feldstein used monthly data from the Bureau of Economic Analysis (BEA) of the US Department of Commerce. In a detailed critique of these regressions, Lewis and Seidman (2012) emphasized that the rebates in 2001 and 2008 were paid out in only six months, three months in each year (a tiny amount of rebate was paid out in the month before and the month after the three months in 2001 and 2008). Hence, even though Taylor’s sample runs 106 months (from January 2000 to October 2008) and Feldstein’s sample runs a much larger number of months (from January 1980 to November 2008), they each had only six months in their sample with a tax rebate.

Taylor and Feldstein both said that the rebate variable was “statistically insignificant” and that their regressions therefore proved that the rebate had no effect. Lewis and Seidman point out that “insignificant” meant only that, given the large standard error due to the small number of rebate months, the hypothesis that the true rebate coefficient was zero couldn’t be rejected; it didn’t mean the hypothesis that rebate coefficient was zero should be accepted. Taylor and Feldstein certainly knew this basic distinction between rejection and acceptance, taught in every introductory econometrics course and textbook, but they misled readers by asserting that their regressions proved that a rebate had no effect on consumption.

Lewis and Seidman examined the variables in Taylor’s equation. In Taylor’s regression, the dependent variable was personal consumption expenditure (PCE), and there were only three right-hand variables: lagged PCE, rebate payments (which occurred only in three months in 2001 and three months in 2008), and disposable income excluding any rebate payments (DPY). Taylor stated that the rebate was statistically insignificant and much smaller than the statistically significant impact of disposable personal income excluding the rebate. But Lewis and

Seidman replied that this wasn’t surprising because there were 106 months of data on disposable income but only six months of data on a tax rebate—three months in the summer of 2001, and three months in the summer of 2008—too little tax rebate data to precisely estimate its impact. Neither Feldstein nor Taylor alerted readers to the implications of the fact that they had only six months of tax rebate data. They gave the impression they were as certain about the impact of tax rebates as they were about the impact of regular disposable income, without warning readers that they a lot more data on disposable income than they had on tax rebates.

Lewis and Seidman criticized Taylor for omitting several variables that were surely bringing down consumption in mid-2008 when the rebates were paid out. Housing prices were falling, home foreclosures were rising, Bear Stearns had been barely rescued in March, the index of consumer sentiment was collapsing, and the stock market was plunging. As rebate checks were being received in June, the University of Michigan’s consumer sentiment index fell to a low point of 56.4 (in contrast to its January value of 78.4) and the Dow Jones average plunged 1,288 points. All of these downward currents together certainly pulled down personal consumption expenditures. Yet Taylor apparently did not try to control for these downward currents.

Lewis and Seidman found that inclusion of the consumer sentiment index nearly doubled the estimated coefficient and the t-statistic of the rebate. Inclusion of the Dow Jones average (instead of the consumer sentiment index) had an effect similar to the inclusion of the consumer sentiment index; it raised the estimated rebate coefficient and t-statistic. Finally, the inclusion of both the consumer sentiment index and the change in the Dow Jones average had a stronger effect on the rebate coefficient than either one alone. The estimated rebate coefficient became

slightly greater than half of the estimated disposable income coefficient.

Lewis and Seidman said that the hypothesis that a rebate had roughly half as much positive impact on consumption as regular disposable income definitely could not be rejected and actually seemed roughly accurate. This hypothesis was proposed years ago by Alan Blinder (1981) based on his econometric study of the effect of temporary tax changes and transfers on consumption using aggregate times-series data. Blinder concluded that a temporary tax change had half the impact of a permanent change of equal magnitude.

Next Lewis and Seidman addressed Feldstein’s regressions. In contrast to Taylor, who presented his regression results with details in a table, Feldstein (2009) provided only a paragraph. He said that he and Stephen Miran estimated a consumer expenditure equation using monthly data from January 1980 through November 2008. They estimated that the marginal propensity to consume out of real per capita disposable income was 0.70 but the estimated MPC from the corresponding rebate variable was only 0.13 (standard error 0.05). The other variables in the equation were the unemployment rate and the 10-year interest rate. In response to Feldstein, Lewis and Seidman noted that Feldstein did not include the consumer sentiment index or the change in the Dow Jones average to capture consumer anxiety. The unemployment rate variable was not a satisfactory substitute because it lagged behind the economy. For example, in May 2008 the unemployment rate was still only 5.4%. By contrast, the consumer sentiment index had already plunged.

Finally, Lewis and Seidman made one other important point: neither Taylor nor Feldstein reported regressions with quarterly data, which are commonly used in macroeconometric models. Moreover, quarterly data may be preferable for testing the impact of a rebate on consumption because when a

household receives a rebate check, it usually deposits the check, initially raising its saving, and only gradually raises its spending over the next year, so one month might not be enough time to detect the impact of the rebate on spending. Lewis and Seidman ran the same regressions with quarterly data and found that the performance of the rebate variable was stronger than with monthly data. The two-quarter MPC was fairly stable at roughly 0.28 and the four-quarter MPC was fairly stable at roughly 0.44.

In summary, I reach these conclusions. Although many economists and policy makers have heard that Taylor of Stanford and Feldstein of Harvard showed that tax rebates don’t work, both of their studies were flawed. Neither Feldstein’s arithmetic in his Wall Street Journal op-ed nor Taylor’s chart in his Wall Street Journal op-ed showed that the rebate failed, contrary to their assertions. Their regressions using monthly data, reported in their articles, don’t yield a precise robust coefficient estimate for the tax rebate variable because there were very few months with a tax rebate—rebates were paid in only six months (three months in 2001 and three months in 2008) out of the 106 months in Taylor’s sample (January 2000 to October 2008). Their rebate coefficient estimates and standard errors were very sensitive to the inclusion of other plausible variables that they excluded, like the stock price index and the consumer confidence index, which both plunged during the period when the rebates were received. Lewis and I showed that the hypothesis that the true rebate coefficient is half the true ordinary disposable income coefficient could not be rejected and in fact seemed likely to be roughly accurate. Taylor and Feldstein misinterpreted their regression results and claimed erroneously that their regressions showed that tax rebates don’t work. Economists and policymakers should be informed that that Taylor’s and Feldstein’s studies of tax rebates are deeply flawed and their conclusions about tax rebates should therefore be discounted.

Sahm, Shapiro, and Slemrod’s Study of the 2008 Tax Rebate

The claim by Feldstein and Taylor that the 2008 rebate failed was soon echoed by Shapiro and Slemrod, who in a paper presented at the January 2009 annual conference of the AEA said their new fall 2008 consumer survey showed that “only one-fifth of consumers mostly spent” the rebate. Their paper was published in May 2009 in the annual Papers and Proceedings of the AEA. With a new coauthor, they published a second article on the 2008 rebate in a 2010 volume (Sahm, Shapiro, and Slemrod 2010) on tax policy.

They admitted their survey did not ask how much of the rebate was spent (the MPC), but they claimed they could estimate it was “about one-third,” using assumptions that I described earlier when they tried to deduce the MPC out of the 2001 rebate from their consumer survey questions that did not ask for the respondent’s MPC. Their MPC estimate of one-third applied to the four months remaining in 2008 after the rebate was received in the summer. But with the bias they injected by asking recipients to think about their “financial situation” instead of about goods and services they badly needed, my interpretation is that the results of their 2008 rebate consumer survey imply that over 40% of the rebate was spent within four months. Note this is the same as my interpretation of their 2001 rebate study (Seidman 2003).

Parker, Souleles, Johnson, and McClelland’s Study of the 2008 Tax Rebate

With Feldstein; Taylor; and Sahm, Shapiro, and Slemrod all asserting in 2008 and 2009 that the 2008 tax rebate was largely ineffective, policymakers did not enact another tax rebate despite

the deepest and most prolonged recession since the 1930s. With a Democratic president and Democratic majorities in the House and Senate in 2009 and 2010, significant fiscal stimulus was enacted despite near-unanimous opposition from Republicans in Congress. One of the elements of the fiscal package, the Making Work Pay tax credit, was at first glance similar to a tax rebate in trying to get more cash into the pockets of consumers, but was implemented very differently: by a cut in income tax withholding with each paycheck instead of a rebate check mailed out from the US Treasury. And in 2011 and 2012, the Republicans were willing to support a cut in the employee payroll tax withholding as a replacement for the cut in income tax withholding under the Making Work Pay tax credit. After 2012, the cut in payroll tax withholding was terminated, so that for the first time since 2008 there was no longer any tax method—either large tax rebates or cuts in withholding—being used to get more cash in the pockets of consumers during the slow recovery of 2013 and 2014.

Unfortunately, it took until the October 2013 issue of the American Economic Review before Johnson, Parker, and Souleles, now joined by McClelland, published their study of the 2008 rebate using essentially the same methodology and data source that they had used to study the 2001 rebate. They explained that the rebates were paid out to households over a nine-week period and that the final two digits of a household’s Social Security number determined which week the household received its rebate. They closely followed the methodology of Johnson, Parker, and Souleles, which analyzed the 2001 tax rebates. With the cooperation of the staff of the BLS, they added additional questions to the Consumer Expenditure Survey. These supplemental questions asked CE households to report the amount and month of receipt of each stimulus payment they received.

Their main finding is the opposite of the early claims of Feldstein; Taylor; and Sahm, Shapiro, and Slemrod. They

estimated that spending was slightly larger and faster out of the 2008 rebate than had been estimated in the study of the 2001 rebate. They estimated that within three months of receiving the 2008 rebate the average household spent about one-half of its rebate (instead of about one-third). More than half the spending was on durable goods and related services, so less than half was on nondurable goods and services. They reported that their results were economically and statistically significant across a variety of specifications.

Because their estimate of spending out of the 2008 rebate was only slightly larger and faster than the estimate of spending out of the 2001 rebate, I summarize the estimates from these two studies this way: about one-third of a rebate was spent within three months, and about two-thirds was spent within six months.

Johnson et al. provided some useful details about the 2008 tax rebate. To speed the payments to households, the Treasury used its data from tax year 2007 returns, so only those filing 2007 returns received the payments. If subsequently a household’s tax year 2008 data implied it was entitled to a larger payment, the household could claim the difference on its 2008 return filed in 2009. But if the 2008 data implied a smaller payment, the household did not have to return the difference. Households without tax liability received basic payments of $300 ($600 per couple) so long as they had at least $3,000 of qualifying income (which includes earned income and Social Security benefits). The total stimulus payment phased out with income, being reduced by 5% of the amount by which adjusted gross income exceeded $75,000 ($150,000 for couples). In aggregate the stimulus payments in 2008 were historically large, amounting to about $100 billion, which in real terms was about double the size of the 2001 rebate program. The stimulus payments constituted about two-thirds of the total ESA package.

Johnson et al. noted that they generally maintained consistency with the methodology they used in their study of the 2001 rebate. Their main estimating equation had the dependent variable equal to the increase in the household’s consumption from t to t+ 1, and independent variables that included the amount of the ESP and control variables. Lags in ESP were used to allow for gradual impact over time on spending. They presented ordinary least squares (OLS) results with the dollar change in the individual household’s consumption expenditures as the dependent variable and the contemporaneous amount of the payment (ESP) to that individual household as the key independent variable. The resulting estimate of the coefficient measured the average fraction of the payment spent within the three-month reference period in which the payment was received. Johnson et al. looked carefully at subsets of consumer durables and found a key role for vehicles. Auto purchases, although weakening during the recession, would have been even weaker in the absence of payments. They noted that their finding of a large spending response on new cars implied an important role for liquidity constraints: the tax rebate may have helped provide down payments for debtfinanced purchases of cars.

Broda and Parker’s Study of the 2008 Tax Rebate

In contrast to the studies that used data from the Consumer Expenditure Survey of the Bureau of Labor Statistics, this study by Broda and Parker used different data, the Nielsen Consumer Panel (NCP). To measure the spending effects of the economic stimulus payments (ESPs), they conducted a survey of roughly 60,000 households in the NCP during the spring and summer of 2008. The NCP contained annual information

on household demographics and income, and weekly information on spending on a set of household goods. Participating households were given barcode scanners to report spending on households goods. Broda and Parker prepared a supplemental survey, designed in conjunction with Nielsen, that collected information on the date of arrival of the first ESP received by each household, as well as its amount. They identified the change in spending caused by the receipt of an ESP at the household level, using the fact that the particular week in which the funds were disbursed depended on the second-to-last digit of the taxpayer’s Social Security number.

Broda and Parker estimated that the propensity to consume from a tax rebate was 30% to 45% of the rebate amount during the quarter of disbursement and 20% to 30% during the following quarter; hence, roughly one-third was spent within three months and two-thirds within six months. Households in the bottom third of the 2007 income distribution had larger propensities to spend out of their EPSs in the month of arrival than households in the top third. Households in the bottom 40% of the distribution of liquid wealth spent at roughly triple the rate of the rest of the households during the month of receipt, and at roughly double the rate during the three months starting with receipt, so that households with low liquid wealth accounted for the majority of the estimated spending response.

Parker’s Summary of Tax Rebate Research

Parker (2014) summarized his research (with coauthors) on tax rebates and his conclusions for policy. He presented evidence that rebate-type payments policies generated substantial increases in demand for goods and services. In particular, a large portion of tax rebates were spent rapidly.

Parker said that a decade ago there was general agreement that central banks should combat recessions by cutting interest rates; fiscal stimulus was unnecessary. Parker was unfortunately correct that almost no one among the leading economists at elite universities argued for fiscal stimulus in the 1990 recession or the 2001 recession—either “New Keynesians” or “New Classicals.” Unfortunately, Parker did not mention that the minority of economists who were traditional (not “new”) Keynesians in fact did call for fiscal stimulus in both of those recessions (see Seidman 2001 and 2003).

Parker noted that since the plunge into severe recession in 2008, there had been some revival in interest in fiscal stimulus. Several empirical studies confirmed that transfer payments to households can provide timely and temporary economic stimulus. In 2001 and in 2008, the United States distributed more than 2% of quarterly GDP in tax rebates to the majority of US tax filers within a few months of the start of each recession. Distributing tax rebates to stimulate demand is at odds with the textbook understanding of economic behavior according to which one-time payments are not spent immediately but instead used to raise spending a small amount over many years, a lifetime, or forever. Further, many economists believed that households would assume that rebates in the present implied higher taxes in the future and would therefore save their rebates to pay the future taxes.

Let me interrupt Parker to point out that traditional Keynesians have always agreed that consumers respond more to a $1,000 raise from their employer (permanent income, Friedman) than a $1,000 tax rebate in recession, and that when consumers receive a one-time tax rebate in recession they will spread some of it (life cycle planning, Modigliani). But traditional Keynesians have never accepted the claim by Barro (1974) that consumers will save the entire $1,000 tax rebate because

they think they better get ready to pay future taxes. Barro has never shown a shred of empirical evidence that ordinary people think this way, yet his hypothesis, called Ricardian equivalence, has been accepted by many economists and has been assumed in models presented in advanced textbooks and journal articles.

Parker cited his own research with coauthors. They found that the arrival of a tax rebate caused a significant increase in spending over the next few weeks. The effect declined over time, but the cumulative effect was large. Households spent threequarters of the rebate within three months on durables and nondurable goods and services (one-quarter on nondurables). The majority of spending was done by households with insufficient liquid assets to cover two months of expenditures (about 40% of households). These households spent at a rate six times that of households with sufficient liquid wealth.

Rebates versus Cuts in Withholding

The fiscal stimulus package called the American Recovery and Reinvestment Act (ARRA) authorized federal spending of roughly $800 billion over 2009 and 2010 (hence, roughly $400 billion per year). It was enacted into law in February 2009 with virtually unanimous support from congressional Democrats and virtually unanimous opposition from congressional Republicans. Instead of enacting a 2009 tax rebate as a follow-up to the 2008 rebate, the Democrats inserted in the fiscal package a Making Work Pay tax credit recommended by the president that would give a single individual a $400 income tax credit and a married couple an $800 credit. The Making Work Pay tax credit could have been implemented as a tax rebate—the US Treasury could easily have mailed $400 or $800 checks to households in 2009 just as it mailed rebate checks in 2008.

Instead, a reason was given for cuts in withholding from each paycheck instead of a tax rebate mailed to the household. It was argued that if small increments in funds were integrated into regular paychecks through small cuts in withholding, then employees would spend the small increments in funds the same way they spent most of their paycheck. But surely an important reason for making the switch was the incorrect claim by economists Feldstein, Taylor, and Sahm et al. that empirical studies showed that little of the 2008 rebate had been spent.

I published an article in Tax Notes (Seidman 2009) that explained in numerical and diagrammatic detail how the $400 and $800 Making Work Pay tax credit would be implemented by changing specific numerical amounts withheld in each paycheck, and discussed various aspects and options for the withholding method of delivering cash to households, such as whether the amount of the withholding cuts should be changed every quarter in light of the path the economy was taking.

It soon became apparent, however, that one great practical difference between rebates and withholding cuts had not been sufficiently appreciated. Tax rebate checks sent by regular mail from the US Treasury to individual households seldom escaped the notice of most recipients. Publicity occurred for weeks in 2001 and 2008 from the president and members of Congress, who wanted to make sure voters knew they had enacted the tax rebates. Also, the media told people to watch their mail for their rebate check from the US Treasury. No doubt a few people may have tossed out the envelope from the US Treasury with other junk mail. But most people in 2001 and 2008 watched their mail for the US Treasury envelope they had heard so much about, opened the envelope eagerly when it came, and deposited it quickly. Depositing an $1,800 rebate check (for two adults and two children in the household) makes the adult depositor aware that the federal tax rebate program has made the household

$1,800 richer—that the household has the ability to spend, pay down debt, and save a total of $1,800 more than it otherwise would have, thanks to the rebate check.

By contrast, surveys showed that many individuals were completely unaware of the withholding cut due to the Making Work Pay program. This isn’t surprising. The change in the dollar amount in each paycheck was small and was often deposited directly by the employer into the employee’s bank account. Even if an individual noticed a small change in withholding or takehome pay, the reason for the small change in withholding might be unclear. The amount withheld out of a paycheck often varies by a small amount month to month for a variety of reasons. There was no easy way for even an observant individual to know why these small changes had occurred in her paycheck and whether it would be reversed in her next paycheck. Thus, even the observant individual had no way to know whether the small withholding change meant she had really become richer for the rest of year, and therefore would be able to afford to buy more goods and services.

Many individuals didn’t notice the withholding change because the change did not require the individual to take any action. Either your paycheck is deposited in your bank by your employer, or you make your monthly (or biweekly) deposit of your regular paycheck that you receive once or twice every month in the mail or from your employer at work, but nothing alerts you to look at the numbers to see if they’ve changed, and if you do look at the numbers, there is no action for you to take.

By contrast, if a rebate check is sent to you by regular mail, in an envelope labeled US Treasury, you must take an unusual action. You have to open an envelope you usually don’t receive from the US Treasury and then deposit this special check. It is true that some individuals did not have to take action because their 2008 rebate check was electronically deposited in their

bank account. In the future, to make sure everyone is aware of receiving a tax rebate, it would be better to have all rebate checks sent through regular mail. It is easy to alert the public to watch for a large rebate check in the mail, to explain in a short cover note that rebates are being sent only because of the recession or weak recovery, and that they won’t be repeated unless the economy becomes even weaker. That’s what happened when tax rebates were mailed out to the majority in 2001 and 2008.

The Republicans, who won back a majority of the House in the November 2010 elections, were particularly eager to get rid of the Making Work Pay credit when it expired at the end of the 2010 because it had been recommended by President Obama. With a tax rebate still widely thought to be ineffective, what else might be done? Some Republicans feared being accused of levying a tax increase if they simply ended the Making Work Pay cut in withholding, thereby causing a small increase in withholding and a small cut in take-home pay. Even though many employees probably wouldn’t notice the change, Republicans worried that some would notice. So at the end of 2010, Democrats and Republicans came to an agreement to get rid of the Making Work Pay cut in withholding and replace it with a cut in employee payroll tax withholding from 6.2% to 4.2%. It was quickly agreed by both Republicans and Democrats that the loss in payroll tax revenue to the Social Security Trust Fund would be immediately made up by an equal infusion in general revenue, so there would be no change in the funds in the trust fund and no change in anyone’s Social Security benefits.

One serious problem with this payroll tax cut was that it began to generate nervousness among elderly and older workers, and therefore across the political spectrum, that somewhere down the road the general revenue reimbursements might fall short of fully compensating for the lost payroll tax revenue, and that the Social Security Trust Fund and retiree benefits would eventually

be weakened if this “temporary” payroll tax cut continued year after year. So after being extended from 2011 to 2012, a majority in both parties agreed to end the temporary cut in the payroll tax from 6.2% to 4.2% and restore the full 6.2% starting in 2013.

The Design of a Future Tax Rebate

A tax rebate is a return to the taxpayer of a portion of income, payroll, and sales taxes paid in the previous tax year. In the most recent tax rebate, 2008, the rebate was the same dollar amount per adult ($600), and per child ($300), for most households. Based on the income tax return of the previous year (2007), the rebate was phased down and out for high-income households, phased down for low-income households that had paid less income tax than the standard rebate amount (the rebate could not exceed the amount of income tax the household had paid), and there was no rebate for households with very low income (less than $3,000).

In my view there is an economic and political advantage in giving every household a rebate, though not necessarily the same dollar amount. Almost every household has borne a burden from some tax—income tax, payroll tax, and/or sales tax. A valid way to make more low-income households eligible for a tax rebate is to recognize the burdens from payroll and sales taxes.

It is impractical and unnecessary for the IRS to try to determine each household’s exact payroll tax or sales tax burden in the preceding year. Using the wage income reported on the household’s 1040 return, the IRS can take 12.4% of the household’s wage income up to last year’s Social Security ceiling as the IRS’s estimate of the household’s Social Security payroll tax burden; and take 2.9% of the household’s wage income as the IRS’s estimate of the household’s Medicare payroll tax burden.

The IRS should use 12.4% rather than 6.2%, and 2.9% rather than 1.45%, because economic analysis implies that workers bear nearly the entire burden of the payroll tax because employers reduce wages in order to pay the employer payroll tax. The IRS can use 5% of total income reported on the 1040 as its estimate of the household’s sales tax burden; even in states without a sales tax, prices may be bid up as border shoppers choose to shop across the border so that shoppers bear some burden from a sales tax in adjacent states.

Although recognizing payroll and sales tax burdens will make most low-income households eligible for a substantial tax rebate, some may still have zero tax burden in the preceding year. In my view it would be worth setting a minimum tax rebate for all households even if that minimum amount exceeds the estimated total tax burden of the household.

I also recommend, in contrast to the tax rebate of 2008, phasing down but not out the tax rebate for high (and even very high) income households. It is true that high-income households usually have a lower propensity to consume than low-income households. But there is evidence that most high-income households do have a positive marginal propensity to consume. Some even have a propensity as large as the typical low-income household (Kaplan, Violante, and Weidner 2014).

Sending tax rebates to the affluent, the poor, and everyone in between during a recession should broaden the political support for tax rebates. To make sure that every household recognizes that it has received a tax rebate, I recommend that all tax rebates be sent by regular US mail rather than deposited electronically in bank accounts. A check in the mail requires the recipient take several concrete actions: opening the envelope, recognizing that a check is enclosed, looking at the short letter explaining why the check has been sent, and then depositing the check in a bank account or cashing the check. There is bound to be media

coverage of individuals opening envelopes from the US Treasury containing their rebate check, and the media will communicate the fact that every household will be receiving a rebate check in the mail. This widespread awareness of tax rebates should boost support for the tax rebate program.

Conclusion

The impact of tax rebates in the 2001 recession and in the 2008 recession has been subject to a set of studies by highly respected economists. The three studies that in my view used the best methodology and data to estimate the impact of tax rebates on consumer spending in a recession (Johnson, Parker, and Souleles 2006; Parker et al. 2013; Broda and Parker 2014) estimated that tax rebates were very effective in stimulating consumer spending: about one-third was spent within three months and about two-thirds was spent within six months. By contrast, the studies that concluded that these rebates had little effect had serious flaws, as explained in detail in this chapter.

Whenever the US economy is hit with a recession, tax rebates should be the mailed out with a size that fits the severity of the recession. Suppose a recession reduces real GDP by 6% below normal, which is estimated to raise the unemployment rate by three percentage points—for example, from 5% to 8%. To simplify the calculation, assume that the fiscal stimulus consists entirely of tax rebates (in the next chapter I will make the case for including several other programs in the fiscal stimulus package). To raise GDP by 6% would require total tax rebates equal to 6% of GDP, assuming a tax rebate multiplier of 1.0 in a recession. If the rebate is to be paid out twice a year—for example, in June and December, then each payment would be 3% of GDP. Suppose in 2018 potential GDP is $20,000 billion and a recession hits.

This would require total tax rebates by the US Treasury in June, and then in December, of 3% of $20,000 billion, or $600 billion in June, and then $600 billion in December. With a US population of roughly 300 million, the average rebate in June and in December would be $2,000 per person. Congress might specify that the rebate to each household would be $2,667 per adult and $1,333 per child in June and in December, so a household with two adults and two children would receive an $8,000 tax rebate check in June and in December. Under stimulus without debt, the Fed would make a transfer to the Treasury of $600 billion in June and $600 billion in December, so that the Treasury does not have to borrow to finance the tax rebates.

Chapter 5

What about Other Kinds of Fiscal Stimulus?

In this book I argue that tax rebates to households should be the main component of a fiscal stimulus package in a severe recession for the reasons and evidence given in chapters 3 and 4. In this chapter, I consider other fiscal stimulus programs that might be included with tax rebates in a fiscal stimulus package. The chapter begins with several fiscal stimulus programs that I recommend for inclusion. Then I examine several other fiscal stimulus programs and explain why I don’t recommend them. Next I review and comment on components of the fiscal stimulus enacted in early 2009 and implemented in 2009 and 2010—the American Recovery and Reinvestment Act (ARRA). I then explain a common mistake made by many economists that leads them to underestimate the “multiplier effect” of fiscal stimulus programs. Finally, I report on and evaluate several empirical studies of fiscal stimulus programs utilized in the Great Recession.

Recommended Supplements to Tax Rebates

In this section I recommend several fiscal stimulus supplements to tax rebates for inclusion in a fiscal stimulus package: a temporary increase in federal aid to state governments, temporary tax incentives for business investment, and infrastructure repairs and maintenance.

A Temporary Increase in Federal Aid to State Governments

I recommend a temporary increase in federal aid (grants) to state governments. A formula should be used for distributing the aid across states. In a recession, most of the aid will be spent, not saved, thereby helping to combat the recession. A recession automatically reduces tax revenue at all levels of government— federal, state, and local. If the governmental unit responds by cutting its spending or raising its tax rates in an effort to keep its budget balanced, it will further reduce aggregate demand for goods and services, thereby making the recession worse. Just as tax rebates help sustain consumer spending when the recession reduces household income, so temporary federal grants to state governments, which in turn provide temporary grants to local governments, should help sustain state and local government spending, and also help sustain consumer spending by reducing state and local tax increases needed to balance governments’ budgets.

Moreover, federal aid to state governments should be (as it usually is) implemented according to an objective numerical formula based, for example, on the state’s population, income per capita, unemployment rate, and so on. Such a formula spreads the federal aid across all states. If the elements included in the formula are generally perceived as fair, federal grants have the

potential to win the support of a majority of voters, thereby generating support for passage of the fiscal stimulus package by Congress. Use of a formula minimizes favoritism and porkbarrel politics. Politics will certainly play a role in choosing the elements that enter the formula and the numerical weights given to each element. But once the formula is set, the funds going to each state are not affected by political dealing and lobbying.

Another simple method would be to raise the federal matching rate for Medicaid (the “Federal Medical Assistance Percentage,” FMAP). This was done under the fiscal stimulus bill enacted in February 2009, which will be described below. Medicaid is a matching federal/state program, and Medicaid constitutes a large percentage of state government spending in most states. During a recession, more households qualify for Medicaid. Raising the federal matching rate is a simple and quick way to inject federal funds into state governments.

Even these simple methods of injecting federal funds into state governments are subject to objections by critics. Some critics believe that just as a recession forces households to “tighten their belts” and cut spending, so all levels of government should have to “tighten their belts” and cut spending. Of course, tax rebates attempt to ease the belt tightening of households. Some critics of government “waste” believe a recession is a good time to squeeze some of the waste out of government. Some conservative critics hold that recession is a good time to reduce the size of government at all levels—federal, state, and local. If the federal grants are specifically targeted to a large list of particular programs and projects, then there is criticism of favoritism and pork-barrel politics; many opponents of the 2009 fiscal stimulus package made this criticism. Some opponents have argued that federal grants will be almost entirely saved by state governments, just as some opponents of tax rebates have argued that rebates are almost entirely saved. But one of the empirical studies reviewed

at the end of this chapter provides an estimate of how much is saved, and this study estimates that a substantial percentage of the grant is not saved.

As opponents point out, there is some risk that the federal grants that are intended to be temporary will not be ended when the economy recovers from the severe recession. In both the 2001 and 2008 recessions, however, temporary federal grants to states were in fact ended once recovery began. The grants were enacted for a particular year, and once recovery occurred, Congress did not renew them for the next year. Ideally, it might be better to enact the grants with a clause that automatically winds down and terminates the grant according to an indicator such as the unemployment rate. But past behavior by Congress shows that such a “terminator clause” may not be necessary.

Temporary Tax Incentives for Business Investment

Tax rebates to households, by raising consumer spending, should indirectly cause an increase in business investment because firms producing consumer goods and services will need to expand their capacity to meet the rise in customer demand. It might be argued that tax rebates for households provide sufficient stimulus for business investment. Nevertheless, there are several good reasons why a tax incentive for firms to invest in plant and equipment should be included in a fiscal stimulus package.

Over the past half-century, two tax incentives encouraging business firms to buy plant and equipment have been enacted in the United States: (1) an investment tax credit; (2) bonus depreciation. Under the first, a firm receives a tax credit on its income tax equal to a certain percentage of its expenditure on an investment good—in effect, a firm is reimbursed by the federal for that percentage (for example, 20%) of its expenditure. Under the second incentive, a firm is permitted to depreciate a certain

percentage (for example, 50%) of its expenditure on an investment good on its income tax in the year of purchase in addition to its regular depreciation, thereby reducing its taxable income and its tax that year. If Congress uses the word “temporary” in the title of the legislation for business tax incentives, it puts pressure on business firms to act during the recession to take advantage of the temporary cut in the price of investment goods while it lasts.

There are two reasons for including temporary tax incentives for business investment in a stimulus package. First, most economists agree that a temporary cut in the price of investment goods should, in theory, induce some increase in purchases. Second, inclusion of a program that directly sends funds to business firms that invest may improve the political feasibility of the fiscal stimulus package. For example, the 2008 fiscal stimulus package contained two components: a tax rebate that directly sent funds to households (two-thirds of the package), and a bonus depreciation tax incentive that directly sent funds to business firms (one-third of the package). The 2008 fiscal stimulus package passed with bipartisan support.

There is a risk, however, that advocates of permanently lower tax rates on business firms will press to continue the tax incentive even after a strong recovery from the recession has been achieved. The effectiveness of the tax incentive to stimulate investment spending during the recession will be weakened if business managers believe it will be permanent, not temporary, just as a 50% price cut during a sale at a retail store will stimulate less consumer spending if consumers believe the price will be permanent, not temporary. It might be particularly important to include language indicating that the incentive is temporary, intended only to combat the recession, or even include a terminator clause that phases it out as the unemployment rate declines to normal.

Infrastructure Repairs and Maintenance

There is strong bipartisan support in all sections of the country for infrastructure spending to repair and maintain current roads and bridges. For federal infrastructure this would involve direct federal spending; for state and local infrastructure, this would involve federal grants to state governments earmarked for this purpose. This program would promptly increase spending in every state, but this spending directly increases demand in only certain sectors of the economy—construction firms and workers and the materials they use. By contrast, tax rebates spread their increase in aggregate demand across most goods and services in the economy, and federal aid to states stimulates all state and local government spending, not just infrastructure maintenance. Thus, infrastructure spending for repairs and maintenance is a useful small complement to, but not a substitute for, a large tax rebate or federal aid to states.

A fiscal stimulus bill in a severe recession is not the place to put new, costly, controversial long-term infrastructure projects. In contrast to repairs and maintenance, new infrastructure projects involve significant delays in starting construction. Each of those projects should be subjected to cost-benefit analysis, should not be judged as an antirecession measure, and should be voted on separately from the fiscal stimulus package.

Not Recommended

In this section I explain why I do not recommend the following in a fiscal stimulus package: a temporary cut in income tax withholding, a temporary cut in payroll taxes, a cut in income taxes, or an increase in spending on long-term programs.

Two different criteria guide the decision not to recommend the following policies for inclusion in a fiscal stimulus package in

a severe recession. First, the tax rebate to households dominates the other ways listed below to get cash to households to increase their consumption spending. Second, the fiscal stimulus package devised to combat a severe recession should not be used to achieve and implement a long-term agenda by either liberals (Democrats) or conservatives (Republicans). Instead, the aim should be to construct a fiscal stimulus package that is effective against the severe recession and neutral concerning the longterm agenda of each side, so that the package can be enacted quickly with bipartisan support and renewed if the recession is more severe than expected. The place and time for partisan debate over long-term agenda policies should be outside the fiscal stimulus package and after it is enacted.

A Temporary Cut in Income Tax Withholding

Mailing out tax rebate checks to households is better than a cut in income tax withholding. A tax rebate was enacted only in the first year of the Great Recession, 2008. In 2009, the new president was a Democrat and Democrats had a majority of both the House and Senate. Together the Democrats fashioned and passed the American Recovery and Reinvestment Act, which contained many fiscal stimulus programs and will be discussed more fully later in this chapter. The bill was passed over the virtually unanimous opposition of Republicans in the House and Senate. Instead of including a repeat of the 2008 tax rebate to households as one component of ARRA, the Democrats replaced it with a program advocated by candidate Obama during his campaign in 2008 called “The Making Work Pay Tax Credit.” Like a tax rebate, the Making Work Pay Tax Credit provided more cash in the pockets in a majority of the nation’s households in the hope that they would use a significant portion of the cash to buy goods and services, thereby stimulating production of these goods and

services. Most households received a credit of $800. Like the 2008 tax rebate, the MWP tax credit excluded the affluent.

There was, however, one crucial difference between the Making Work Pay Tax Credit of 2009 and the tax rebate of 2008. The tax rebate of 2008, like the tax rebate of 2001 and 1975, was a single large check sent out in an envelope by regular mail to each household by the US Treasury (though a minority of households did receive their rebate through an electronic deposit from the Treasury to the individual’s bank account). By contrast, the Making Work Pay Tax Credit was paid out in small amounts in each worker’s paycheck by cutting the income tax withheld by the employer.

Most households that received the tax rebate in 2008 were aware of receiving the large rebate check in the mail and depositing it in their bank, so most knew how much they had received from the rebate. They received a cover letter telling them this money came from the president and Congress. They knew that if their rebate check was $1,200, they were $1,200 richer and could afford to increase their spending up to $1,200 without borrowing. By contrast, in 2009 most households were not aware of receiving a small cut in income tax withholding due to the Making Work Pay Tax Credit, and therefore a small increase in take-home pay. Small changes in withholding, and in take-home pay, occur for many reasons, and surveys showed that many workers did not even notice the change, or if they did notice, did not realize it was due to the MWP tax credit. Most important, most did not feel richer, and therefore did not think they could afford to do $800 more in spending, saving, and paying down debt.

A Temporary Cut in Payroll Taxes

Mailing out tax rebate checks to households is better than a temporary cut in the employee Social Security payroll tax rate. When

the Making Work Pay Tax Credit expired at the end of 2010, the Republicans had regained a majority in the House and were opposed to renewing the MWP tax credit. Instead of turning back to tax rebates, the two parties agreed on a two-percentage-point cut in the Social Security payroll tax for employees, from 6.2% to 4.2% in 2011. Over a year’s time, an employee earning $40,000 would receive $800 more in take-home pay. Like the MWP tax credit, the cut in the employee payroll tax rate was implemented by a small reduction in withholding in each worker’s paycheck and thus a small increase in take-home pay in each paycheck. As in the case of the cut in income tax withholding, surveys showed that many workers were unaware of the change in takehome pay, or if they noticed the change, did not know why it had changed. Many employees did not feel $800 richer after a year had passed than they would have felt without the reduced tax, and they may not have felt they could afford to do $800 more in spending, saving, and paying down debt.

For policymakers and for citizens who were aware of the cut in payroll taxes, moreover, the cut raised concern about whether it would weaken the finances of Social Security and the benefits of current or future retirees. The legislation enacting the twopercentage-point cut in the payroll tax stipulated that general revenue would annually replace the reduction in payroll tax revenue coming into the Social Security Trust Fund so that the finances of the fund would remain unchanged and benefits to all Social Security recipients current and future would be unaffected. But some were concerned that eventually political pressure to use general revenue to fund other programs might reduce the funds flowing into the Social Security Trust Fund. Although the payroll tax cut was renewed in 2012, it was allowed to expire at the end of 2012, so that in 2013 the payroll tax rate reverted from 4.2% to 6.2%. This relieved the fears of those who worried, during 20111 and 2012, about the financing of Social Security.

A Cut in Income Taxes

Most conservatives and Republicans support a permanent cut in income tax rates as a central element in their long-term agenda of reducing tax revenue and government domestic spending as a percentage of GDP and giving permanent incentives for people to supply more labor and capital to the economy because they keep more of what they earn. Many liberals and Democrats oppose a permanent cut in income tax rates because it would prevent a central element in their long-term agenda of strengthening social insurance and education programs. To combat a severe recession, mailing out tax rebate checks is better than a cut in income tax rates, which should be debated between conservatives (Republicans) and liberals (Democrats) as a matter of long-term policy.

An Increase in Spending on Long-Term Programs

Many liberals and Democrats support a permanent increase in spending on social insurance, education programs, and environmental projects as a central element in their long-term agenda of providing the general public with more protection and opportunity, but many conservatives and Republicans oppose this role for government and the higher taxes it requires. These permanent spending increases should be debated as long-term policies, not as elements of a temporary fiscal stimulus package to combat a severe recession.

Rebates and Bonuses in 2008, ARRA in 2009–2010, and Fiscal Stimulus in 2011–2012

In February 2008 a $150 billion fiscal stimulus was enacted— 1% of the GDP of $15,000 billion—consisting of $100 billion of tax rebates to households mailed out in the summer, and $50

billion of bonus depreciation for business firms to encourage investment spending. It was enacted with bipartisan support and signed by President Bush. In the fall of 2008, as the economy plunged into deep recession following the failure of Lehman Brothers, President Bush failed to propose, and Congress failed to enact, another fiscal stimulus, despite urgent newspaper columns from some economists, including me. In my judgment, this was a major policy failure that has not received the attention it deserves.

The American Recovery and Reinvestment Act (ARRA) was enacted in February 2009 just one month after a new Democratic president, Barack Obama, took office, with Democrats having a majority in the House and nearly (but not quite) sixty votes (out of one hundred) in the Senate. Democrats therefore had the votes to pass a stimulus bill containing components that were consistent with their long-term objectives and therefore almost unanimously opposed by Republicans. ARRA included several government spending programs favored by Democrats as permanent policies. In the 2001 recession, when a Republican occupied the White House and Republicans had a majority in Congress, the stimulus bill promoted the Republicans’ long-term agenda by enacting long-term (10-year) cuts in all personal income tax rates, with larger tax cuts, as measured by the total dollar amount, going to high-income households.

In defense of the Democrats’ stimulus bill, it must be emphasized that the Republicans showed no interest in a fiscal stimulus package in the fall of 2008, especially one containing any government spending. The Democrats recognized that it was up to them to shape a fiscal stimulus bill and pass it without Republican votes. Some Democrats also wanted to use the fiscal stimulus to advance their long-run agenda.

Here is my rough estimate of the impact of fiscal stimulus (tax rebates and bonus depreciation) of 1% of GDP in 2008 and ARRA in 2009 and 2010. ARRA was enacted in February 2009

and began entering the economy in April 2009. The US unemployment rate had already shot up from 5.0% in April 2008 to 9.0% in April 2009. ARRA was a roughly $750 billion fiscal stimulus package implemented mainly over two years (2009 and 2010)—roughly $375 billion per year, or 2.5% of GDP ($15,000 billion) per year. Thus, the average fiscal stimulus per year from 2008 through 2010 was 2% of GDP (the average of 1%, 2.5%, and 2.5%).

Conservatively assuming a fiscal stimulus multiplier of 1.0, GDP was raised an average of 2% per year above what it otherwise would have been. Assuming a ratio between the increase in GDP and the reduction in the unemployment rate of 2, fiscal stimulus reduced the unemployment rate one percentage point below what it otherwise would have been; with fiscal stimulus the unemployment rate reached a peak of 10% in October 2009, but without fiscal stimulus, the unemployment rate would have peaked at 11%.

The message from this calculation is that the fiscal stimulus certainly helped, but was simply too small for the Great Recession. At the time, some economists, including me, wrote columns calling for fiscal stimulus at least twice as large. I now think the stimulus should have been three times as large. If fiscal stimulus had been 6% of GDP in 2008, 2009, and 2010 instead of averaging 2% per year, the unemployment rate would have been reduced 3%, not 1%, from 11% to 8%, not from 11% to 10%. If further strong stimulus had been continued in 2011 and 2012, instead of being blocked by the House Republican majority that was elected in November 2010, a strong recovery would have been generated that would have brought the unemployment down to 5% by 2013 instead of 2015, as was actually the case.

In its account five years after ARRA’s enactment, the Obama administration’s Council of Economic Advisers (CEA) presented its analysis of the impact of ARRA (chapter 3 of The Economic

Report of the President 2014). The half of professional economists (including me) who believe that fiscal stimulus works in a recession find the CEA analysis of the ARRA’s impact on the economy largely accurate, but the other half of professional economists who believe that fiscal stimulus does not work in a recession do not. Most economists, however, would find the information about the ARRA provided in the CEA’s chapter to be very useful.

The chapter begins with an important fact: President Obama signed the ARRA on February 17, less than a month after taking office. I want to emphasize that the speed with which the new Democratic majority in the House and Senate enacted the ARRA stands as a refutation of the conventional view that fiscal stimulus always takes many months to enact.

There is a common impression that the two-year ARRA, implemented in 2009 and 2010, was the entire fiscal stimulus implemented during the Great Recession. But the CEA pointed out that this impression is incorrect. In the four years following passage of the ARRA, the president signed into law over a dozen fiscal measures aiming to speed job creation.

Critics have claimed that the fiscal stimulus (the ARRA and subsequent fiscal stimulus measures) enacted during the Great Recession was wasteful government spending. But the CEA replied that nearly half of the job measures in the ARRA and subsequent legislation were tax cuts—with most of them directed at families. The other half was for rebuilding bridges and roads, supporting teacher jobs, or providing temporary help for the unemployed.

The CEA provided additional information about the ARRA. The initial cost projections showed the law would be fairly evenly distributed across tax cuts ($212 billion billion), expansions to mandatory programs such as Medicaid and unemployment benefits ($296 billion), and discretionary spending ($279 billion) in areas ranging from direct assistance to individuals to

investments in infrastructure, education, job training, energy, and health information technology. Although over a fourth of ARRA stimulus was tax cuts to individuals, most people were unaware of this component—the Making Work Pay Tax Credit— because it was implemented through small cuts in withholding in each paycheck. The CEA provided this additional information about the subsequent fiscal stimulus measures.

There is a common impression that fiscal stimulus ended after 2010 because the Republicans, who had criticized fiscal stimulus, regained a majority in the House in the November 2010 election. But the CEA report showed that this was not so. The Obama administration succeeded in getting Republicans in the House to maintain roughly 80% as much fiscal stimulus as the ARRA (2% of GDP per year instead of the ARRA’s 2.5%) in 2011 and 2012.

While the ARRA was the first and largest fiscal action undertaken after the financial crisis to create jobs and strengthen the economy, many subsequent actions extended, expanded, and built on the ARRA. Parts of the act were extended to address the continuing needs of the economy, including Emergency Unemployment Compensation, accelerated depreciation of business investment for tax purposes (that is, “bonus depreciation”), measures for teacher jobs, and aid to states for Medicaid. In other cases, new measures expanded on elements in the ARRA, such as the temporary payroll tax cut in 2011 and 2012, which was nearly 50% larger than the Making Work Pay credit it replaced, and an even greater allowance for businesses to write off the cost of investments when computing their tax liability (that is, “expensing”).

There is also a common impression that the Obama administration never asked for an enlargement of fiscal stimulus after ARRA. But this is untrue. The president proposed further measures for the economy, most notably the American Jobs Act, which was proposed in a special speech to a joint session of

Congress in September 2011 and would have provided additional investments in everything from infrastructure to teacher jobs to a robust tax credit for small business hiring. But the House was unwilling to pass it.

The CEA said that most studies have found that fiscal stimulus (the ARRA and subsequent measures) helped stop the plunge in the economy and helped generate the economic recovery (several empirical studies of the impact of the ARRA will be examined later in this chapter). Most studies found that the ARRA substantially boosted employment and output. The CEA estimated that, by itself, the act saved or created an average of 1.6 million jobs a year for four years through the end of 2012. In addition, the ARRA alone raised the level of GDP between 2% and 2.5% from late 2009 through mid-2011.

In a future recession, in contrast to the ARRA, it would be better to enact a fiscal stimulus package that is neutral with respect to the long-term agenda of conservatives or liberals, because such a package can be enacted even when there is divided government, with no single party (Democrat or Republican) having the presidency and a majority in the House and sixty (enough to prevent a filibuster) out of a hundred senators. It would be better to establish a tradition that a fiscal stimulus package to combat a severe recession is not the time or place to push for measures that favor only one party’s long-term agenda. It is, of course, politically tempting for a party that controls the White House and Congress to push measures that advance its long-term agenda. But this guarantees that the other party will attack the stimulus package and try to discredit it with the public.

It is certainly debatable whether in early 2009 Republicans and Democrats would have been willing to put aside longterm priorities and join in supporting the neutral fiscal stimulus package advocated here. Whose fault was it that the fiscal stimulus bill that was actually enacted—the ARRA—favored

the long-term priorities of Democrats? Some Republicans insist they would have supported a politically neutral package but Democrats preferred a partisan bill. Other Republicans admit they would have opposed any fiscal stimulus bill because of their worry about government deficits and debt. In the second half of 2008, as the recession deepened, it is a sobering fact that neither the Republican president nor Republicans in Congress proposed a large fiscal stimulus package. After the November 2008 election, Democrats felt it was urgent to move quickly to enact a strong fiscal stimulus package, and that time would be wasted trying to negotiate a bipartisan, strong, neutral package with Republicans.

Although the ARRA was not ideal in its composition, in my view the evidence is strong that it was effective: without it the recession would have been deeper and lasted longer. However, it is also likely that the stimulus package would have been larger, and would have been sustained for four years instead of two, and therefore have been much more effective, if it had been neutral toward long-term priorities and if both parties had been willing to put aside long-term priorities and concerns about government deficits and debt to pass a neutral package.

A Common Mistake in Estimating Fiscal Multipliers

Some economists have contended that the CEA assumed fiscal stimulus multipliers larger than have been found in pre-2008 empirical studies of the quantitative relationship between fiscal stimulus and the resulting increase in output. Unfortunately, many (not all) of these studies have made a fundamental mistake in estimating multipliers—a mistake that results in a significant underestimate of the effectiveness of fiscal stimulus in a severe

recession when the “output gap” is large—that is, when actual output is far below potential output (the output that would be produced if labor were fully employed and the real capital stock were used to full capacity).

A fiscal stimulus multiplier is the ratio of the increase in output to the increase in government spending or tax cut that generates it. Assume the economy is at full employment and full capacity utilization when the government increases spending or cuts taxes. With hardly any unemployed labor or capital available, real output hardly increases in response to an increase in government spending or a tax cut, so the multiplier is near zero. By contrast, suppose the economy is in a severe recession with high unemployment and low capacity utilization. Then the increase in spending or tax cut would cause employers to hire unemployed workers and utilize idle machines, thereby increasing real output; hence, the multiplier would be positive. Moreover, the newly employed would enjoy an increase in income, enabling them to raise their consumption spending, inducing producers of consumer goods to hire unemployed workers, utilize idle machines, and raise real output, thereby making the multiplier larger. What matters for fiscal stimulus to combat a recession is the size of the multiplier in a recession when unemployment is high and capacity utilization low, not the size of the multiplier in a fully employed economy.

Consider the textbook aggregate-demand/aggregate-supply diagram shown in Figure 5.1, in which the supply curve is initially flat but curves upward to become steep at the full-employment level of real output Y0 (Seidman 2012a, 2012b). When the economy is in severe recession at a low value of real output, Y1, with high unemployment and low capacity utilization, a shift right of aggregate demand (D) can raise real output with only a slight bidding up of wages, costs, and prices, so the aggregate supply (S) curve is relatively flat. But when the economy is at full

P S

D' D'

D

D

Y1 Y2 Y0

FIGURE 5.1 The Stimulus Multiplier in Recession vs at Full-Employment

Y

employment output Y0, a shift right of aggregate demand curve mainly bids up wages, costs, and prices, with hardly any increase in real output Y, so the aggregate supply curve is steep. Thus, when the economy is in a severe recession, a shift right of the D curve by magnitude ∆D causes a relatively large increase in real output ∆Y—from Y1 to Y2 —hence, the multiplier is large—but when the economy is at full-employment output Y0, a shift right of the D curve by the same magnitude ∆D causes a relatively small increase in real output ∆Y—hence, the multiplier is small. Thus, it is a fundamental error to estimate the value of the multiplier in a fully employed economy and then assume this value holds when the economy is in or still recovering from a severe recession.

Yet Robert Barro made exactly this error. He tried to estimate a value for the multiplier using data from a fully employed economy and then asserted that this multiplier value would hold when the economy was in a severe recession. Barro summarized

his research in a truly revealing article in Economists’ Voice entitled “Voodoo Multipliers” (2009). He argued that the best evidence of the size of the multiplier came from the massive expansion of US defense expenditures during World War II. There was a dramatic reduction in the US unemployment rate from 1939 through 1942 driven partly by the sharp rise in military and related spending in preparation for a possible entry into a world war from 1939–1941 and actual entry in 1942. An analysis confined to 1939 to 1942 might therefore have been useful. Instead, Barro focused on 1943–1944 when the US economy was at full employment. He estimated that World War II raised US real defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943–1944, amounting to 44% of trend GDP. He also estimated that the war raised real GDP above trend by $430 billion per year in 1943–1944. Thus, the multiplier was 0.8 (430/540).

Barro is not the only economist who estimated the magnitude of the fiscal stimulus multiplier in a recession by using data generated in an economy that was not in recession. There is a large empirical literature that presents regressions of the change in real output against the change in government spending or taxes for all quarters in the sample. But only a small fraction of the quarters in the sample were recession quarters, so these studies mainly estimate the value of the multiplier when the economy is not in recession. What matters for countercyclical fiscal policy, however, is the value of the multiplier when the economy is in or still recovering from recession so there is still substantial slack in the economy.

One empirical study (Auerbach and Gorodnichenko 2012) focused specifically on distinguishing between the numerical value of the government purchases multiplier in a recession versus its value in an expansion. Using a regime-switching model, they found large differences in the size of spending multipliers in recessions and expansions, with fiscal policy being much more

effective in recessions. Their finding was consistent with the traditional Keynesian explanation: when the economy has slack, expansionary government spending shocks are unlikely to crowd out private consumption or investment because idle labor and capital can be brought into production. They criticized the majority of empirical studies of fiscal multipliers that don’t provide separate estimates for multipliers in recession, noting that much empirical research in this area is based on models that assume that multiplier values don’t depend on the state of the economy. They described exactly my AD-AS diagram in Figure 5.1. The AS curve is flat at low levels of output (Y)—recession—but becomes steep at high levels of output (Y)—full employment of labor and utilization of capital. When AD shifts right in recession, it generates a large increase in Y; but when AD shifts right at full employment, it generates a large increase in P but only a small increase in Y. They found that the size of the size of the multiplier varied considerably over the business cycle. Typically, the multiplier is between 0.0 and 0.5 in expansions and between 1.0 and 1.5 in recessions. A dollar increase in government spending in 2009 during the Great Recession would raise output by about $1.75.

Auerbach and Gorodnichenko (2013 extended their analysis of the government purchases multiplier to other OECD countries, and found that multipliers of government purchases were larger in a recession. They concluded that their results were consistent with the traditional Keynesian model, but not with New Keynesian or New Classical models. They noted that the New Keynesian model doesn’t have spare capacity or slack, a key feature of the traditional Keynesian model. They observed that during the Great Recession, many countries adopted expansionary fiscal policies aimed at counteracting the large negative shocks to their economies, despite of skepticism among many economists about the potential of fiscal policy to stimulate

economic activity. Their two studies found that fiscal stimulus worked in recession—it raised mainly real output, not inflation, and multipliers were large. Their empirical results contradict the assumption of New Keynesian models that crowding out is large and the fiscal multiplier is small. Instead, their results are consistent with the traditional Keynesian model, which assumes a recession is characterized by “slack”—labor that is involuntarily unemployed and machines that are idle.

Empirical Studies of the ARRA Fiscal Stimulus (2009–2010)

I will now review several empirical studies of fiscal stimulus using data from 2009 and 2010. Recall that the American Recovery and Reinvestment Act was enacted in February 2009 and its funds were injected into the economy from spring 2009 through the end of 2010 (with some spending continued beyond 2010).

Fiscal Spending Jobs Multipliers: Evidence from the 2009 ARRA

This subsection heading reproduces the title of an article by Daniel Wilson (2012). Under the ARRA, federal grants to states varied according to a formula. Wilson applied regression analysis to a cross section of states to determine to what extent jobs in a state were affected by ARRA funds received in that state from the federal government. His strategy was to exploit the crosssectional geographic variation in ARRA spending and the factors that determined that variation.

Wilson explained that, in contrast with studies of the economic effects of fiscal stimulus that rely on time-series variation, the use of cross-sectional variation greatly reduces the risk

of confounding fiscal stimulus effects with effects from other macroeconomic factors, such as monetary policy, that are independent of the geographic distribution of stimulus funds. His study made use of the fact that most of the ARRA funds were allocated according to statutory formulas based on exogenous factors such as the number of miles of highway in a state and the youth share of its population. Wilson noted that his study measured local multipliers and did not include reverberations outside the region.

Wilson explained how his methodology differed from two other methodologies that have been used to measure the impact of ARRA on jobs. The first methodology employs a large-scale macroeconometric model to obtain a no-stimulus forecast and compares that to a simulated forecast where federal government spending includes the ARRA. This is the methodology used in reports by the Congressional Budget Office, the White House’s Council of Economic Advisers, and private forecasters such as Macroeconomic Advisers, HIS Global Insight, and Moody’s Economy.com, as well as a number of academic studies. The second methodology is an attempt to count the jobs created or saved by requiring first-round recipients of certain types of ARRA funds to report the number of jobs they were able to add or save as a direct result of projects funded by ARRA. These counts are aggregated across all reporting recipients by the Recovery Accountability and Transparency Board (RATB), which was established by ARRA. But the number of jobs created or saved reflects only first-round jobs tied to ARRA spending, such as hiring by contractors and their immediate subcontractors working on ARRA-funded projects, and excludes both second-round jobs created by lower-level subcontractors and jobs created indirectly due to spillovers such as consumer spending made possible by the wages associated with these jobs. By contrast, Wilson’s methodology used employment totals as reported by the Bureau of

Labor Statistics so that all direct and indirect jobs created by ARRA would be reflected in the results.

Wilson estimated that ARRA spending created or saved about 2.1 million jobs, or 1.6% of pre-ARRA total nonfarm employment, in its first year. Jobs created or saved grew to 3.4 million by March 2011. He noted that his results were in line with estimates of the ARRA’s impact generated by studies using the macroeconometric modeling approach.

Does State Fiscal Relief during Recessions Increase Employment?

This subsection heading reproduces the title of the study by Chodorow-Reich, Feiveson, Liscow, and Woolston (2012). Like Wilson, they applied regression analysis to a cross section of states. But unlike Wilson, they focused on Medicaid spending. They tried to determine how jobs in a state were affected by ARRA Medicaid funds received by that state from the federal government. Most state and local governments have balanced-budget requirements that limit their borrowing even in a recession, so when recession reduces tax revenue, these governments are under pressure to lay off employees, cut spending and transfer programs, and raise tax rates. The designers of the ARRA sought to give fiscal relief to state and local governments by directing roughly a third of the ARRA’s funds to these governments. An important share of ARRA funds was used to increase the federal match of state Medicaid expenditures.

Chodorow-Reich et al. noted that few studies focused on the response of state and local governments to federal grants aimed at combating a recession. Federal grants might have a small or zero immediate impact on economic outcomes if states simply used them to bolster their rainy-day funds, saving instead of spending the federal funds. On the other hand, states might use

the money to reduce tax increases or avert spending, allowing money to enter the economy more quickly than direct federal purchases that require project selection and approval.

They decided to focus on the federal Medicaid match for several reasons. First, the amount of money distributed through this program was large enough to plausibly generate a detectable effect on employment. Out of a total of $88 billion dedicated to an increase in Medicaid matching funds, states had received $61.2 billion by June 30, 2010, the end of the Chodorow-Reich et al. period of study. Second, increasing the federal match effectively transfers money into state budgets that states can use for any purpose—the money is fungible. Many states reported that the increase in the Medicaid match enabled them to allocate money quickly to areas that otherwise would have undergone deeper budget cuts. Third, the level of additional money received by states as of June 2010 per person age 16 or older varied greatly across states, from a low of about $100 to a high of about $500. This variation made possible a cross-sectional econometric strategy. Chodorow-Reich et al. focused their analysis on the effect on jobs because the effectiveness of the ARRA centered largely on its impact on jobs. Moreover, high-quality monthly state-level employment data made it possible to obtain more precise estimates of fiscal multipliers than were possible with the existing state-level income data. The ARRA increased the percentage of Medicaid expenditures that the federal government paid for all states by 6.2 percentage points and increased the match rate by more for states that experienced especially large increases in unemployment. Like Wilson, Chodorow-Reich et al. noted that their study measured local effects and ignored reverberations outside the recipient state.

They found that ARRA transfers to states for Medicaid had an economically large and statistically robust positive effect on jobs. They estimated that $100,000 in Medicaid transfers resulted in

nearly four jobs that lasted one year; they estimated that three of the four jobs were outside the government, health, and education sectors, implying that the states must have used the funds to avoid tax increases or spending cuts. Moreover, the federal transfers did not appear to have increased the states’ end-of-year balances.

Macro Fiscal Policy in Economic Unions: States as Agents

This subsection heading reproduces the title of article by Carlino and Inman (2016). They noted that a striking feature of the ARRA was its reliance upon intergovernmental transfers to state and local governments for implementing central government macroeconomic fiscal policy. Carlino and Inman used time-series data over the last several decades, in contrast to the studies by Wilson and by Chodorow-Reich et al. reviewed above, who used data only from 2009 and 2010 following the enactment of the ARRA during the Great Recession.

A major concern about the Carlino and Inman study is that they did not isolate the state response to federal aid during recessions from the state response when the economy was not in recession. The Carlino and Inman estimates were based on data generated every year over the past several decades, so the results they reported were a weighted average of state response to federal aid in a normal economy and state response in recession, with a much larger weight for the response in a normal economy. In a normal year when state or local tax revenue is sufficient to avoid spending cuts, it is conceivable that a substantial share of federal aid might be saved in a rainy-day fund. But in a recession, when tax revenue has fallen and spending cuts are looming, it is more likely that a large portion of federal aid will be used to avoid unpopular spending cuts that would cause hardship, rather than

to build a rainy-day fund. Hence, Carlino and Inman’s estimates for state response to federal aid in an average year in their sample are likely to substantially underestimate the state response to federal aid in a recession.

For an average year in their sample (not a recession year), their estimate of the GDP multiplier for federal project aid was modest—between 0.0 and 1.0—and not statistically significant, but the multiplier for federal welfare aid was large—between 1.6 and 2.3—and statistically significant. They estimated that states saved about half of federal project aid and spent all of matching welfare aid on lower-income assistance and tax relief for general taxpayers. I conjecture that multipliers for both project aid and welfare aid in a recession year would be much higher than their estimates for an average year.

An Empirical Analysis of the Revival of Fiscal Stimulus in the 2000s

This subsection heading reproduces the title of an article by John Taylor (2011). Taylor has probably done more to oppose fiscal stimulus in a recession than any other American economist. In this Journal of Economic Literature article, a journal read by many academic economists, Taylor wrote about other components of a fiscal stimulus package as well as tax rebates. In the abstract for his article, Taylor stated that none of the components of the fiscal stimulus packages enacted in the United States since 2000 actually worked in recession. He claimed that households saved tax rebates, and state and local governments saved their federal aid. In chapter 4, I critiqued Taylor’s articles in opposition to tax rebates. Here I will critique his analysis of federal aid to state and local governments.

In a recession, state and local tax revenue falls, but state and local governments are required to balance their budgets as

soon as possible. These governments may delay balancing their budgets by emergency borrowing, but before long they will be forced to choose one of two very unpopular alternatives: cutting spending or raising taxes. Suppose emergency federal aid is now given to these governments. Taylor claims these governments will save the emergency aid and cut spending programs and raise taxes just as much as if there were no additional federal aid. How many state or local officials who must run for re-election would support saving the federal aid instead of using the aid during a recession to avoid either unpopular spending cuts or unpopular tax increases?

Here is a simple numerical example I constructed that casts doubt on Taylor’s claim that federal aid in a severe recession had no effect on the expenditures of a state or a local government. Table 5.1 shows possible impacts of a recession and federal aid on the budget of a state or a local government. In any row of the table, Tax Revenue + Federal Aid + Borrowing = Expenditures + Gross Saving. The left side gives the sources of funds for the government, and the right side gives the uses of funds. Note that

TABLE 5.1 The Impact of Federal Aid on State and Local Expenditures in Recession

Year Tax revenue

Federal aid Borrowing Expenditures Gross saving 0N $ 950 $190 $ 0 $1,140 $ 0 1N $1,000 $200 $ 0 $1,200 $ 0 1R $ 800 $200 $ 0 $1,000 $ 0 1RB $ 800 $200 $ 140 $1,140 $ 0 1RA $ 800 $340 $ 0 $1,140 $ 0 1RAS $ 800 $340 $ 0 $1,000 $ 140

Note: In each row, tax revenue + federal aid + borrowing = expenditures + gross saving.

Total Revenue = Tax Revenue + Federal Aid. Also note that net saving is defined as gross saving minus borrowing, so moving borrowing to the right of the equation would change the gross saving term to net saving. In Table 5.1, borrowing is $0 in every row except one (row 1RB), so in all other rows gross saving and net saving are equal.

If the economy were normal (N)—not in recession—in years 0 and 1, it would experience normal growth from year 0 to year 1 and would move from row 0N to row 1N. I assume there would be normal federal aid of $190 in year 0 and $200 in year 1, and that the budget would be balanced each year, with borrowing and gross saving each equal to $0. To simplify the numbers, I assume each number in row 0N is 95% of the corresponding number in row 1N—equivalently, that there would be 5.3% growth in each number from year 0 to year 1 if the economy stayed normal. In row 1N, total revenue, which equals tax revenue ($1,000) plus federal aid ($200), equals expenditures ($1,200).

Now suppose the economy falls into recession in year 1, automatically reducing tax revenue to $800. Consider the possibilities for year 1 with the recession. Rows 1R, 1RB, 1RA, and 1RAS give four possible outcomes.

In row 1R, I assume normal federal aid (the federal aid that would have occurred in a normal economy in year 1) is $200 in row 1N, and that the government is required to keep its budget balanced. In this row I assume that borrowing and saving are each $0. With tax revenue $800 and federal aid $200, expenditures would equal $1,000, which is $200 less than in row 1N ($1,200)— what it would have been in year 1 without recession—and $140 less than last year in row 0N ($1,140).

There are two ways to prevent expenditures from falling to $1,000 in year 1. The first is to permit the government to borrow as shown in row 1RB. The second is to increase federal aid as shown in row 1RA.

In row 1RB, the government is permitted to borrow, and it borrows $140, just enough to prevent a cut in spending below last year’s $1,140 in row 0N, but still below $1,200 in row 1N. With expenditures $1,140 and total revenue (tax revenue plus federal aid) equal to $1,000, the government deficit is $140. Note that net saving, defined as gross saving minus borrowing, is −$140 in this row.

In row 1RA, the government must balance its budget. I assume borrowing and gross saving are each $0. But federal aid increases $140 from $200 to $340, so expenditures are $1,140. Thus, when the S&L government is unable to borrow, $140 of additional federal aid can prevent it from having to reduce expenditures below $1,140.

Finally, row 1RAS shows the outcome that Taylor claims will occur despite a $140 increase in federal aid (from $200 to $340). In row 1RAS, expenditures are still only $1,000, just what would have happened in row 1R without an increase in federal aid. This happens because the government chooses to respond to the $140 increase in federal aid by increasing its gross saving by $140 and cutting its expenditures to $1,000, which is $140 below last year’s expenditures ($1,140 in row 0N). Taylor claims the government would choose this outcome even though such an unpopular cut below last year’s expenditures ($1,140) could have been prevented just by keeping gross saving at $0 ($1,140 in 1RA).

It is very unlikely that the government would choose Taylor’s row 1RAS in a recession. With popular and political pressure to avoid severe expenditure cuts that cause hardship, it seems much more likely that a state or local government would give top priority to avoiding severe expenditure cuts rather than to increasing gross saving, so that the government is much more likely to choose row 1RA rather that Taylor’s row 1RAS. Thus, as shown in row 1RA, the increase in federal aid would prevent a severe cut in expenditures rather than cause an increase in gross saving.

Conclusions

In chapters 3 and 4, I made the case for having tax rebates to households be the largest component of any fiscal stimulus package to combat a recession. In this chapter, I recommended certain fiscal stimulus programs for inclusion in a fiscal stimulus package (along with tax rebates to households), but recommended against inclusion of certain other fiscal stimulus programs. For each fiscal stimulus program I explained why I recommended for or against inclusion. I recommended these programs for inclusion: (1) a temporary increase in federal aid (grants) to state governments; (2) temporary tax incentives for business investment (for example, an investment tax credit, or bonus depreciation); (3) a temporary increase in federal spending for infrastructure repairs and maintenance (either direct spending by the federal government or grants to the states for this purpose). I recommended against these programs: (1) a temporary cut in income tax withholding; (2) a temporary cut in payroll taxes; (3) a cut in income taxes; (4) an increase in spending on long-term programs. I described and commented on components of the fiscal stimulus enacted in early 2009 and implemented in 2009 and 2010—the American Recovery and Reinvestment Act (ARRA). I then discussed a mistake made by many economists that leads them to underestimate the “multiplier effect” of fiscal stimulus programs. Finally, I reviewed and evaluated several empirical studies of fiscal stimulus programs utilized in the Great Recession.

Chapter 6

Would Stimulus without Debt Be Inflationary?

Would stimulus without debt be inflationary? This question should be divided into two parts. First, will stimulus without debt generate inflation before the economy fully recovers from the recession? I will explain why my answer is no. Second, can stimulus without debt be phased out by the time the economy reaches full employment so that it doesn’t generate inflation? I will explain why my answer is yes.

Stimulus without Debt Is Not Inflationary in Recession

Inflation is defined as rising prices. Prices and quantities of goods and services are determined by demand and supply for goods and services. When demand increases for goods and services, how much of the increase in demand will go into raising quantities of goods and services, and how much will go into raising prices? It depends on whether the economy is in recession or at full employment.

Suppose the economy is in a recession with high unemployment and low capacity utilization, so that unemployed workers would be glad to work even without any increase in wages and idle machines are available for these workers. Then the increase in demand would cause employers to hire unemployed workers and utilize idle machines, thereby increasing real output with hardly any increase in costs or prices, so output would expand with hardly any inflation. By contrast, suppose the economy is at full employment and full capacity utilization when demand increases. With little or no unemployed labor or machinery available, real output would hardly increase in response to the increase in demand. Instead, the increase in demand would bid up wages and prices, generating inflation.

Figure 6.1, a textbook aggregate-demand/aggregate-supply diagram, illustrates these points. In the figure, real output Y is plotted horizontally and the price level P is plotted vertically. Both Y and P are determined by the intersection of the demand

P S

D' D'

D

D

Y1 Y2 Y0 Y

FIGURE 6.1 The Impact of Stimulus on Inflation in Recession vs at Full Employment

curve and supply curve. In a recession, the demand curve intersects the supply curve at Y1, well below Y0. To combat the recession requires policy that increases aggregate demand for goods and services and therefore shifts the aggregate demand curve to the right.

Figure 6.1 illustrates what happens in recession versus full employment when the demand for goods and services increases and the aggregate demand curve shifts to the right. When the economy is in severe recession at a low value of real output, Y1, unemployment is high and capacity utilization is low, so a shift right of aggregate demand (D) can raise real output (from Y1 to Y2) without bidding up wages, costs, and prices, so the aggregate supply (S) curve is nearly flat in this range. But when the economy is at full-employment output Y0, a shift to the right of aggregate demand curve mainly bids up wages, costs, and prices, without much increase in real output Y, so the aggregate supply curve is steep in this range. Thus, when the economy is in a severe recession, a shift right of the D curve causes a large increase in real output (from Y1 to Y2) but hardly any inflation (rise in P). When the economy is at full-employment output Y0, a shift right of the D curve by the same magnitude causes little increase in real output (rise in Y) but instead causes a lot of inflation (rise in P).

The stimulus-without-debt policy should only be used in a recession, not when the economy is at full employment. Figure 6.1 implies that as long as the stimulus-without-debt policy is phased out before the economy reaches full-employment output Y0, it will cause little or no inflation.

Here is another way that economists reach a similar conclusion. If high demand for goods and services pushes the unemployment rate below u n, the rate that corresponds to full employment, employers find it hard to retain their own workers, who have good job options, and employers are therefore compelled to raise wage increases, which raises cost increases and price increases,

so inflation rises. Symmetrically, when the unemployment rate is pushed above un by low demand for goods and services, employers find it easy to retain their own workers, who have bad job options, and employers are therefore able to reduce wage increases, which reduces cost increases and price increases, so inflation falls. Thus, high demand for goods and services and the resulting low unemployment rate cause inflation to rise, and low demand for goods and services and the resulting high unemployment rate cause inflation to fall.

The stimulus-without-debt policy would only be used in a recession, not when the economy is at full employment. The model just described implies that as long as the stimulus-without-debt policy is phased out as the economy reaches un, it will cause little or no rise in inflation.

What’s the difference between the first explanation shown in Figure 6.1 and the second explanation? The first explanation assumes an economy where inflation is initially zero, while the second explanation assumes an economy where inflation is initially constant at a steady low rate. But both explanations lead to a similar conclusion: inflation won’t start or worsen due to an increase in aggregate demand for goods and services as long as the economy has not yet reached full employment.

The experience of the Great Recession is fully consistent with this analysis. In 2009 and 2010, when GDP was far below normal (potential) and unemployment was far above normal (10% instead of 5%), a large fiscal stimulus and monetary stimulus was implemented for two years. In 2009 some critics warned that this combined stimulus would be highly inflationary, and predicted a sharp rise in inflation over the next few years. Inflation, however, stayed constant at a low rate of 2%, not just in the depths of the recession (2009 and 2010), but as the economy the economy gradually recovered from the Great Recession to achieve full employment (2011–2015). As this book goes to press in 2018,

after two years of full employment (2016 and 2017), inflation is still steady at about 2%. So contrary to the warnings of some, the monetary and fiscal stimulus implemented during the Great Recession in 2009 and 2010 has not raised inflation above 2%.

But what would have happened to inflation under stimulus without debt with a fiscal stimulus three times as large as the stimulus implemented in 2009? Recall that at the end of chapter 3, I contended that a fiscal stimulus three times as large was needed to overcome the severity of the Great Recession. The analysis of this section implies that inflation would have stayed at 2%—its rate prior to the recession—because this stimulus would not have reduced the unemployment rate below 5%. The larger stimulus would have generated a faster recovery so that full employment would have been achieved several years sooner than it did. But the phaseout of the stimulus would have prevented the economy from overheating and generating inflation.

Can Money Injected since 2008 Be Withdrawn?

As of mid-2017, the Fed had only just started to withdraw a significant amount of money from the economy because the gradual recovery from the Great Recession took a full decade. The unemployment rate has at last fallen below 5% (from its peak of 10% in 2010); monthly job creation has been adequate, but not strong enough to generate a full-fledged economic boom. Moreover, inflation has remained low, though some critics continue to predict that the Fed’s reversal will fail and inflation will rise sharply.

Starting in 2008, the Fed injected a large amount of “highpowered money” (also called “monetary base”) into the economy by writing checks to buy bonds or make loans. When the Fed writes checks, the recipients deposit them in their bank accounts

so banks receive reserves from the Fed. In normal economic times, banks lend out a large fraction of their reserves, and the borrowers increase their demand for goods and services. But in a severe recession, the banks make few loans partly because anxious consumers and businesses don’t want to borrow, and partly because banks fear their loans won’t be repaid. Critics say the large injections of high-powered money into banks starting in 2008 will eventually cause substantial inflation. If the economic recovery becomes strong, banks will rapidly draw down their huge reserves to make a large volume of loans and give borrowers corresponding checking accounts that they will use to demand goods and services; given the huge stockpile of reserves, critics say this process will rapidly generate excessive demand for goods and services, fueling a significant rise in inflation. They say that the fact that there wasn’t any rise in inflation from 2008 through 2017 does not refute their contention, because it took eight years (from 2008 to 2016) for the economy to finally return to full employment; they say the inflation will finally take off when the recovery grows stronger.

But it would be straightforward for the Fed to withdraw the high-powered money it injected into the economy since 2008 for one simple reason: whenever the Fed injected highpowered money, it acquired assets. As the economic recovery gets stronger, the Fed can and should gradually sell most or all of those assets, thereby withdrawing most or all of the money it injected. The withdrawal of money from banking system would reduce the funds that banks have available for making loans, and this reduction in the supply of loanable funds would cause banks to raise the interest rates they charge household and business borrowers. This rise in interest rates would reduce borrowing and spending by households and businesses, thereby preventing inflationary pressure by keeping aggregate demand for goods and services from rising above full-employment output.

Can Money Be Restored to Normal after Stimulus without Debt?

Can money be restored to normal after the injection of money under stimulus without debt? This question is not easy to answer for one simple reason: when the Fed gives a transfer to the Treasury instead of buying bonds in the open market, the Fed doesn’t acquire assets that can later be sold to reverse the process and withdraw money from the economy. Thus, the answer is no longer obviously yes. But I will now show that if stimulus without debt had been implemented during the Great Recession with a fiscal stimulus three times larger (my recommendation in chapter 3) than was actually implemented, the Fed would have been able to restore money to normal in time to avoid generating inflation as the economy reached full employment.

It must be emphasized that the Fed wouldn’t need to reduce money in the economy to its amount prior to the recession. In a growing economy, the Fed steadily injects high-powered money into the economy by buying bonds so that the amount of money in the economy grows each year in line with the growth of GDP. When stimulus without debt is implemented, money temporarily grows faster than normal, so the amount of money in the economy rises above its normal growth path. The Fed would only need to reduce money to its normal growth path, not to its prerecession amount. To bring money down to its normal growth path, the Fed needs to make money grow more slowly than normal until it reaches its normal growth path. To make money grow more slowly than normal, the Fed would need to buy fewer bonds each year than it otherwise would have bought.

Under the stimulus-without-debt plan that I proposed in chapter 3 for the Great Recession, there would have been a fiscal stimulus equal to 6% (instead of the actual 2%) of GDP each year

from 2008 through 2010, so the Fed’s transfers to the Treasury would have injected an amount of money each year equal to 6% of GDP—$900 billion (GDP was $15,000 billion)—for a total of $2,700 billion over three years. Thus, to bring money down to its normal growth path, the Fed would need to buy $2,700 billion less of bonds than it otherwise would have. In other words, the Fed would need to inject less money through bond buying to offset its injection of money due to its transfer to the Treasury.

From 2008 to 2011 the Fed actually bought $1,200 billion of Treasury securities (its holdings of Treasury securities increased from $500 billion in 2008 to $1,700 billion in 2011) and $800 billion mortgage-backed securities (its holdings of mortgagebacked securities increased from $0 in 2008 to $800 billion in 2011)—a total for these two bonds of $2,000 billion (Federal Reserve Board 2017). Under stimulus without debt, I would have recommended that the Fed purchase only $200 billion of these two bonds instead of the $2,000 billion it actually purchased from 2008 to 2011 ($1,800 billion less), so the Fed’s money injection into the economy from 2008 to 2011, instead of being $2,700 billion above its normal growth path, would have been only $900 billion above its normal growth path.

From 2011 to 2013 the Fed bought $500 billion of Treasury securities and $700 billion of mortgage-backed securities—a total of $1,200 billion (Federal Reserve Board 2017). Under stimulus without debt, I would have recommended that the Fed purchase only $300 billion of these two bonds instead of the $1,200 billion it actually purchased from 2011 to 2013 ($900 billion less), so the Fed’s money injection into the economy from 2011 to 2013, instead of being $900 billion above its normal growth path, would have been $0 billion above its normal growth path. Thus, by 2013 money in the economy would have been back to its normal growth path.

Inflation will only threaten if aggregate demand for goods and services rises above full-employment output. Raising interest rates sufficiently can prevent aggregate demand from rising above the potential output of the economy. The Fed can raise interest rates by reducing the injection of money so that money rises more slowly than GDP; the Fed can do this by reducing its purchases of bonds. This is the standard way that the Fed has raised interest rates in the past.

There are two other policies that the Fed can also use to raise interest rates. Under the first, recommended by Bernanke (2009), the Fed can raise the interest rate it pays to banks on bank deposits at the Fed. Banks won’t make loans to households and businesses at an interest rate less than the interest rate the Fed pays banks for keeping their funds at the Fed, so by raising its rate on bank deposits, the Fed can cause a rise in interest rates facing households and businesses, thereby reducing their borrowing and spending. Under the second policy, recommended by Siegel (2013), the Fed can raise the reserves each bank is required to hold to back its deposits. Raising the bank’s required reserve ratio would reduce the funds banks can supply for loans, and would result in banks charging higher interest rates to borrowers, thereby reducing borrowing and spending by households and businesses.

Finally, fiscal policy could in theory reduce aggregate demand by raising taxes and/or cutting government spending whenever aggregate demand is excessive and threatens to generate inflation. But in practice Congress is very reluctant to raise taxes or cut spending because these actions are unpopular; by contrast, Congress is much less reluctant to enact fiscal stimulus (cut taxes or raise spending) because each component is popular. In practice, then, it is prudent to rely on monetary policy rather than fiscal policy to prevent inflation.

Conclusion

If stimulus without debt had been implemented in the Great Recession, the large fiscal stimulus and the large injection of money from the Fed transfer to the Treasury would have caused little or no inflation. The large stimulus would have raised aggregate demand for goods and services enough to achieve full employment. If demand rose further, the Fed would have been able to eliminate this excess demand by raising interest rates. Although stimulus without debt would have temporarily raised money in the economy above its normal growth path, the Fed would have reduced money to its normal growth path before the economy reached full employment. Thus, stimulus without debt would have brought the economy out of the Great Recession without generating inflation.